The landlord borrowing property tax trap
By Alan Pink, For Tax Insider November 2020
Alan Pink warns of a potential pitfall for unwary landlords and looks at possible remedies.
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Some landlords are finding themselves ‘between the devil and the deep blue sea’ as a result of taxation.
It’s a normal incident of life as a property investor that sometimes they will want to sell one or more of their property portfolio. Sometimes a landlord is effectively forced into making a sale as a result of financial pressures (e.g. from banks) but a new and powerful incentive to selling some or all of the portfolio has recently been presented by what is sometimes referred to as the ‘Osborne tax’.
These pages have bent beneath the weight of quite a lot of discussion of this ‘tax’ recently; but briefly to recap, it consists of the disallowance of loan interest relief on residential properties for higher rate income tax purposes. This phasing in will be complete with effect from the 2020/21 tax year.
The result can be an effectively more than 100% rate of tax on net rental income, as shown in the following example.
|Example 1: Interest relief restriction|
|Mr Optimist is the type of property investor who only sees the bright side of things, and assumes that an increase in property values, once it has started, will go on forever. At the time he was buying, similarly optimistic lenders were available on the market, with the result that he is now in ‘negative equity’.His property portfolio (on a realistic basis) is valued at £1 million, and gives rise to gross rents of £50,000 per year. The borrowing secured on this is £1.1 million, and the interest (it’s all interest-only loans, of course) is £44,000 a year, following the expiry of his initial low fixed rate terms.
Mr Optimist is a higher rate taxpayer by reason of his day job.
Whilst his actual profit is £6,000 (ignoring other expenses such as repairs), his deemed profit for higher rate tax purposes is £50,000 (i.e. gross rents before interest). Allowing basic rate tax relief for this interest, the tax payable on his rents is about £11,000 – significantly more than his actual profit.
Clearly, this sort of situation is likely to be unsustainable financially, and the only way out is to sell property.
Unfortunately, similar causes to what makes the ‘Osborne tax’ so painful in cases like that of Mr Optimist in the example, can make it very difficult indeed to sell a property sustainably; because if you are in ‘negative equity’ (or sometimes even in situations where you aren’t) the capital gains tax (CGT) bill on selling the property can be greater than the amount of money (if anything) you realise on selling the property.
The lure of refinancing
But how can it come about that the tax you have to pay can be more than the net proceeds you receive from selling a property? Why don’t HMRC just tax that amount?
The answer to this question almost always lies in a previous refinancing of the property, to take advantage of a favourable movement in property values. Let’s again look at an example of how this can be the outcome.
|Example 2: Shortfall after property sale|
|Stephen acquired his first investment property (of many) some years ago for £100,000, for which he took out a mortgage of £80,000. As the years rolled on, the value of the property increased, and he used these increases in value to justify borrowing further amounts on the security of the property, in order to provide the deposit for more property acquisitions, and so on.In a period of rapid property price inflation, he secured a valuation of the property at £200,000, and refinanced the original £80,000 mortgage as a £140,000 loan, using the £60,000 to put down for the acquisition of another property. Still further on in time, the property had gone up in value to £300,000, and this enabled him to release (from a brave lender) another £100,000, bringing the total borrowing against the property to £240,000.
A year later, he decided to sell the property, in the face of a comparatively severe correction in property values; the best offer he gets for this sale (which he is being forced to make by other circumstances) is £280,000.
Tax on the £180,000 gain (because he only has the original £100,000 cost to offset against the £280,000 proceeds) is £50,000, at the 28% rate. But the net proceeds of sale, after paying off the lender, are only £40,000. So, he has a £10,000 shortfall after paying the tax.
A similar type of problem can arise where the allowable base cost of the property is less, for any reason, than the actual cost, on the basis of which the lender originally lent the money. Where this is the case, the amount of the initial borrowing (to say nothing of any subsequent refinancing) can be greater than the allowable cost.
This can happen in a number of circumstances, including:
- Where CGT ‘roll over relief’ was claimed on the acquisition of the property, against a gain made on the sale of a previous property;
- Where there is a transfer between spouses, which are deemed to take place at such a value as gives rise to neither a gain nor a loss for CGT purposes; or
- For transfers between companies in the same group, where again a ‘no gain, no loss’ basis applies.
The problem – and some solutions?
Unless you’re fortunate enough to have spare cash lying around, this ‘borrowing trap’ can leave you in an impossible situation. On the one hand, circumstances might be effectively forcing you to sell; but on the other hand, the tax on the sale makes it financially impossible to sell. What, if anything, can be done about this truly gruesome situation (apart from going bankrupt)?
The following thoughts won’t be of use to everyone, but hopefully most people might find some suggestion that is worth pursuing.
- If you are making a part sale of your portfolio, rather than putting all of them on the market, you could obviously do an analysis to identify which of your properties are standing at the lowest capital gains, which will tend to be those acquired most recently. If these also have enough equity in them, you may be able to solve the problem of insufficient cash to pay the tax in this way;
- It may be possible to refinance the property which is targeted for sale, effectively paying off some of the loan on that property, by refinancing other properties in your portfolio;
- More ambitiously in planning terms, you could consider converting the target property into furnished holiday accommodation, if it is not already such. The Budget in March 2020 announced that entrepreneurs’ relief would not be abolished, but the total gains on which you could get the relief over the course of your life is reduced from £10 million to £1 million. At present, furnished holiday accommodation is eligible for entrepreneurs’ relief provided it has been such for at least two years. So, if you have a two year window, conversion to this sort of accommodation could reduce the tax on your gain from 28% to 10%. To qualify as furnished holiday accommodation you have to meet certain detailed criteria, which are beyond the scope of this article.
- More ambitiously still, you could incorporate your whole portfolio in a limited company, and claim ‘incorporation relief’ from CGT. Any subsequent sale of the properties, by the company which now owns them, would take as their base cost the market value of the property at the time it was transferred to the company. However, this is complex tax planning, involving stamp duty land tax liabilities (or equivalent in Scotland or Wales), and shouldn’t be undertaken without the benefit of proper professional advice.
- If the problem which is driving you to sell a property is the Osborne tax, as it so often will be, consider other ways of mitigating the effect of that tax, which would include (depending on your circumstances) transfer to a company, or, alternatively, transfer to a limited liability partnership (LLP) which includes a company as a member. Again, take expert advice on this because it’s certainly not something you should ‘try at home’.
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