Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
How to avoid the buy-to-let crackdown
The buy-to-let sector has faced a crackdown in recent years, with successive Government policies making it harder for landlords to make a profit. Particularly hit are so-called ‘dinner party’ landlords, who have one or two rental properties.
In the past two years the Government has increased stamp duty rates for buy-to-let investors, cut the tax relief available for landlords and made the borrowing criteria applied by mortgage companies stricter for some landlords.
Figures from mortgage lender industry body IMLA already show a significant impact with an 80% fall in new lending for buy-to-let properties between 2015 and 2017.
Here we look at the hurdles, and the ways investors can overcome them.
Hurdle one: tougher mortgage lending
Last year the regulator toughened up the criteria on which mortgage companies determine their lending. Put plainly, this means the amount of rent you have coming in from buy-to-let must be a higher proportion of your mortgage costs than before.
A good rule of thumb is that you need your rent to cover between 125% and 145% of the mortgage payments each month.
The ‘stress rate’, which is the interest rate used to measure borrowing affordability, has also increased to 5.5% in some cases – a further crunch on how much you can borrow.
The rules are even stricter for ‘portfolio landlords’, those with four or more properties. New rules introduced in October last year mean that when portfolio landlords apply to remortgage, the finances on all their properties must be taken into consideration. This is more of an administration headache for investors, particularly those with very large portfolios.
HOW TO FIX IT?
The rules mean more people need their rent to cover 145% of their mortgage costs, but lenders are flexible in certain circumstances, says David Hollingworth, of mortgage broker London and Country.
The rental coverage required is likely to be lower for those fixing their mortgage for a longer term, borrowing less relative to the property’s value, owning the property in a limited company and for basic-rate taxpayers.
For example, the Mortgage Works, a lender, only requires 125% rental cover for a 20% tax payer, but 145% cover if you’re a higher rate or additional rate payer.
Also with the Mortgage Works, someone borrowing 35% of the value would be stress tested at an interest rate of 4.99%, while someone borrowing a higher percentage would be tested at 5.5%.
Hollingworth says: ‘More landlords are going for longer term fixed rates, whether that is down to the potential for rate rises, or lenders offering a preferential interest coverage ratio for longer term fixes, or for portfolio landlords to avoid going through the admin headache so often.’
Hurdle two: scrapped tax breaks
From April last year a valuable tax relief for buy-to-let investors started to be phased out. The Government is removing the ability for landlords to deduct mortgage interest from their rental income, before working out the tax owed. The perk is being scrapped by 25% for each year, until 2020 when it will be eliminated entirely. It will be replaced with a 20% tax credit.
This means that currently landlords can claim 50% of their mortgage interest against their rental income, while next tax year they can claim just 25%.
HOW TO FIX IT?
Basic-rate taxpayers may not be affected by the change. The 20% tax credit applied by the Government means the move is cost neutral for these individuals.
It is possible for those in the higher-rate tax bracket to bring themselves into the 20% basic rate tax band by making larger pension contributions. These individuals need to be able to spare the additional cash, but saving money into a pension reduces your salary for income tax purposes.
This means if you make additional contributions to your company pension or self-invested personal pension you could bring your income below £46,350, and so become a basic-rate taxpayer.
If this isn’t possible, now more than ever it’s important to cut the amount of mortgage interest you’re paying, and to make the property as profitable as possible.
This means a number of landlords are remortgaging onto lower rates.
A small number of landlords are also shifting their mortgage debt from their buy-to-let property to their main home. This is because rates on borrowing on your own home are lower than buy-to-let properties, and so profitability is boosted. However, you will need to have enough income to meet the mortgage affordability criteria, and have enough equity in your property. Seeking the help of a tax adviser or accountant is advisable here.
Another way to avoid the crunch is to own the properties within a limited company, as the crackdown does not apply here.
However, there are drawbacks to using a limited company. There are (relatively low) set-up costs and you’ll need to file an annual return, which may require an accountant. There are still corporation taxes to pay, and dividend taxes when taking income out of the company.
Existing property owners may consider moving their portfolio into a company structure, however, this requires selling the properties and effectively re-buying them inside the company, which may result in capital gains tax and stamp duty bills.
The biggest drawback is that the cost of borrowing within a company structure, compared to doing so individually, is higher. This means any mortgage debt will have a higher interest rate.
Whether it is beneficial to set up a company depends on a number of factors, including the number of properties owned, the income of the investor, and the level of mortgage debt. A tax adviser’s help should be sought.
Hurdle three: The Stamp Duty Surcharge
From April 2016 anyone buying a second home above the value of £40,000 has to pay an additional three percentage points in stamp duty on the purchase.
The rules are complicated, but broadly speaking, if you are not replacing your main residence, you will have to pay the surcharge.
On the average UK property price of £220,000, someone buying a second (or third, or fourth) property will pay £8,500 in stamp duty, compared to £1,900 under the previous system. For a £500,000 home the stamp duty will now be £30,000, compared to £15,000 before April 2016.
HOW TO FIX IT?
There are very few ways to avoid paying this surcharge. You can buy properties under £40,000, as below this threshold the surcharge does not apply. In many areas of the country none will exist at this price, so you may end up buying far away from where you live – which will come with additional costs of getting someone else to manage the buy-to-let.
You also do not pay the surcharge on caravans, mobile homes and houseboats.
Another option is to buy commercial property, as the surcharge does not apply here. This can seem daunting for some novice buy-to-let investors, but mixed-use properties such as a shop with a flat above can be a good place to start.
In the same £500,000 example above, the stamp duty due on a commercial property would be £14,500. No stamp duty is due on the first £150,000 of a commercial property, with 2% due on the tranche from £150,000 to £250,000, and 5% due on any amount above this.
Yields are often higher on commercial properties, and the tenancy periods can be longer. However, mortgage borrowing costs also tend to be higher, and it is harder to get an interest-only deal, as opposed to a repayment mortgage.
Laura Suter, personal finance analyst, AJ Bell