The rapid growth of buy-to-let has seen the number of private landlords reach almost two million, owning one in five homes in the UK. Against this backdrop, however, the government has been making life more expensive for landlords, taxing them at every step from mortgage to purchase and ongoing letting through to sale. This article notes four buy to let and second home tax traps which clients should be aware of.
Reduction in tax relief
Changes in the taxation of buy-to-let properties could leave clients facing much higher tax bills. Under the reforms introduced in April this year, tax relief on residential property finance costs is being restricted from a landlord’s highest marginal tax rate, down to the basic rate of tax over the next four years.
This could increase a landlord’s property profits – that is to say, their taxable income – significantly, meaning that, apart from paying increased income tax, many will be pushed into higher rate tax and various tax traps.
Take for example a landlord earning £45,000 a year, plus receiving £12,000 in rental income and paying out £2,000 in maintenance costs plus £6,000 mortgage interest. As the following chart shows, the calculation of their property profits/taxable income and income tax could change significantly.
Example buy-to-let property profits/taxable income calculation
|Tax year||Rental income||Costs||Mortgage interest||Property profits||Tax @40%||Basic rate tax relief reducer||Overall tax|
Source: Zurich UK
In this instance, not only will a client’s annual income tax liability have increased by £1,200 by 2020/21 (the difference between higher and basic rate tax relief) but, because of the change in the calculation, their taxable income will have soared by 250% to £10,000.
While some landlords may consider moving their portfolio into a limited company to sidestep this and some of the other tax changes, this can be a minefield fraught with alternative taxes and costs.
Child benefit tax trap
As their taxable income increases from the buy-to-let tax changes, clients could also fall into the child benefit tax trap. Using the above example again, if the client was married with three children claiming child benefit of £2,501 a year, the ‘high income child benefit tax charge’ would now apply as their total taxable income would be £55,000, meaning they would lose £1,250 child benefit (1% for each £100 in excess of £50,000), making a total tax increase of £2,450 a year from 2020/21.
And do not forget the personal allowance and tapered pensions annual allowance tax traps could apply at higher income levels. To avoid this, the tax-planning opportunities include transferring the property and rental income to a spouse/civil partner or making a personal pension contribution.
With so many other tax changes afoot, landlords could have overlooked the IHT liability they will be building up, which is unlikely to be covered by the new residence nil-rate band (unless the property was previously a main residence).
Property prices have continued to rise, with the average UK house price in June 2017 being £218,390 – some 41% higher than their low point in April 2009 and substantially higher in central London and other UK capital cities – stoking IHT liabilities for landlords.
Potentially exempt transfers
To avoid IHT, some landlords may have made outright gifts of – or be considering gifting – second properties to adult children. While taking care not to give rise to a gift with reservation of benefit or trigger pre-owned assets tax, however, they may have overlooked the fact this is a potentially exempt transfer (PET) for IHT purposes.
Should they die within seven years, the failed PET will use up the donor’s nil-rate band first, with any excess gift value taxed on the donee. The traditional use of a gift inter-vivos policy (or a series of level term assurances) can cover the donee’s potential liability, but it is the loss of the nil-rate band to the donor’s estate (increasing IHT by up to £130,000) that is often overlooked.
There are various tax planning opportunities available which could address the issues highlighted above. As this is a specialist area of advice it is important to seek out this information from an appropriate financial adviser. Richmond House has this specialist knowledge and are always available to answer your questions.
The Financial Conduct Authority does not regulate Tax or Estate Planning
Julian Kaye Dip PFS
This information is provided strictly for general consideration only. No action must be taken or refrained from based on its contents alone. Accordingly no responsibility can be assumed for any loss occasioned in connection with the content hereof and any such action or inaction. Professional advice is necessary for every case. It does not constitute legal or tax advice and must not be treated as such. All statements concerning taxation are based on our understanding of the current law and HMRC practice, and proposed changes, as at the date of publication. Levels and bases of, and reliefs from, taxation are subject to change. The provision of advice in relation to taxation is not a regulated activity.
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