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Tax tricks for landlords

Created:

3 November 2006

There are a range of ways for homeowners and landlords to cut their tax bills - the trouble is they are not well-publicised and the Treasury has been cracking down on some schemes.

Tax saving is important, though. Rising house prices mean that more and more homes are falling into the inheritance tax net (IHT). Mike Warburton, of accountant Grant Thornton, notes that IHT receipts for the 2006-07 tax year are forecast to be £3.6bn, compared with £2.5bn in 2003-04. And this 42 per cent rise over three years far outstrips inflation, which is forecast to be 12 per cent over the same period.

So it's good to know that despite the chancellor's attacks on some IHT-avoidance schemes, there are still a number of ways you can reduce or avoid IHT on your home. In addition, there are also opportunities for buy-to-let (BTL) investors to cut both their income tax and capital gains tax (CGT) bills.

Inheritance tax

Unless you plan to reduce or avoid the liability, 40 per cent IHT on your house could take a large chunk out of your estate, and might even force your children to sell the family home.

But it need not be too difficult to avoid IHT on your home. The simplest method is for spouses or civil partners to take advantage of the personal exempt allowance, or nil-rate band, which is £285,000 in the current tax year. Remember, though, that doing this requires you to re-register from joint ownership to tenants in common.

Having split ownership of the home in two, you then need to set up nil-rate band wills. When the first partner dies, him or her share of the home can be passed on to their children or beneficiaries, while the surviving partner can remain in place for the rest of his or her life.

But it might be sensible to use a discretionary trust to hold the nil-rate band share of the property to prevent any unpleasant disputes or problems. Although entry charges now apply to all trusts, these only affect payments above the nil-rate band. And using a trust means that you can control succession - otherwise, your children's problems, from poverty to divorce, could lead to them insisting on a sale.

However, is no longer possible simply to give ownership of your home away and then continue to live there. While assets can be gifted away as potentially exempt transfers, which leave your taxable estate entirely after seven years, continued residence means that the assets are still classed as part of your estate.

Income tax

If you are a landlord, either with properties owned outright or as BTL, you should try to reduce the amount of income tax that you have to pay. Rents have lagged behind house-price growth, and yields on residential properties tend to be low, so cutting the tax bill could make letting more attractive as an investment.

In this case, the most obvious thing is to set the mortgage interest off against income tax. You cannot do this with your own home, though, so it makes sense to pay off your own mortgage first before paying off your buy-to-let mortgage.

Some investors might be tempted to use long-term BTL mortgages, hoping to enjoy strong house-price growth over the next 25 years, rather than 10 years. But Justin Modray, of IFA Bestinvest, warns: "That's a riskier game because, if interest rates go up or rents fall, you could be left high and dry."

What's more, you can offset any further borrowings on your property - above and beyond the original mortgage but no higher in total than the property's value - provided that the borrowing has been used for your property investment business.

As well as offsetting mortgage interest, you can also offset expenses. That means you can reduce your tax bill by offsetting any management agents' fees, plus deducting a 10 per cent annual wear and tear allowance (for furnished properties), plus any essential maintenance work. Maintenance work relates to the house as it exists at the moment so, for example, it could cover a new roof, but not an extension. Replacement white goods and furniture can be claimed for, too.

Buildings insurance, ground rent and any maintenance charges can be claimed, in addition. But contents insurance, council tax and water rates can only be claimed if the property is unoccupied. Any loss in rental income from furnished holiday homes can even be offset against future profits.

Or if you are simply letting out a single room, you can earn up to £4,250 a year in rent before any tax must be paid. If your rental income is under £15,000, you only need to show total income and expense figures on your tax return. If your rental income is over £15,000, though, the calculations are more complicated and you must base the tax bill on rent due, not rent received.

You could also take advantage of a non-earnings or low-earning spouse or civil partner's lower tax rate by having the rental income paid to them.

Capital gains tax

If you sell your own home, there is no CGT liability. Otherwise, CGT must be paid above the annual exempt allowance (£8,800 this tax year), subject to taper relief (see table, above).

But transfers between spouses and civil partners are tax-free, so it makes sense to split your BTL holdings in two to take advantage of two sets of exempt allowances (£17,600 between two each year).

Mr Modray points out that another tax-efficient option would be to sell your primary residence and then move into a BTL property for your retirement, especially if you are downsizing to reduce expenses. You could then use potentially exempt transfers to remove the value of your main house from your estate.

Certain properties even count as business assets and receive accelerated taper relief on gains, reducing the taxable gain by 75 per cent after a two-year holding period. For example, properties would be classed as business assets if they are let out to unquoted trading companies as corporate rentals. This also applies to holiday homes (including hotel rooms and caravans). To qualify as a business asset, a holiday property must be available for at least 140 days a year, let for at least 70 days and not to the same person for more than 31 days consecutively. Although such properties qualify for business asset relief on capital gains, different rules apply for the business asset relief from IHT (see other schemes, right).

If you have lived in a property, but then let it out, you may be able to claim principal private residence relief on that, as well as your own home. But you can't elect for a buy-to-let property that you've never lived in to be your primary residence, notes Mr Warburton. "What this applies to is second homes," he says.

However, you can elect for a second property to be classed as your principal private residence for as little as one week, although Her Majesty's Revenue & Customs could demand evidence of your occupation, such as utility bills in your name. This also applies to student houses bought for your children and held in trust.

Having elected a second home as a temporary principal private residence, you are then entitled to lop the past three years of ownership off any CGT bill. For example, if you lived there for a year and owned it for 10 years in total, any gain would be reduced by four-tenths (i.e. 40 per cent).

If you then let out the elected second home, you can also claim lettings relief. Lettings relief is calculated as the lowest of either the principal private residence relief already claimed (yes, you can claim it twice!), or the total chargeable gain during the time the property was let or £40,000.

Elections must be made within two years of purchase, but new windows of opportunity arise if you buy another property or if you get married.

Self-invested personal pensions

Investments made through self-invested personal pensions (Sipps) attract tax relief, but there are severe restrictions on the types of property that you can invest in via a Sipp. You can only invest directly commercial property, and you can only borrow up to 50 per cent of the value of your fund to gear up your investment. So if you invested in property through a Sipp, you would receive basic-rate tax relief of 22 per cent on your contributions, while higher-rate taxpayers can reclaim the remaining 18 per cent via the tax return. In addition, income and gains would be tax-free, although you would have to pay income tax when you drew a pension (but you can take 25 per cent of your fund as tax-free cash).

But you can invest your Sipp in limited partnerships and property syndicates, which may use higher levels of borrowing (up to 85 per cent). Syndicates also offer investment in portfolios of residential property, and it is also possible to invest directly in certain multiple-occupancy residential properties, including student halls, nursing homes and prisons.

Overseas property

UK property investors are becoming increasingly interested in international property markets, both because of the diversification that they can offer and because growth rates may be higher.

But before taking the plunge, you should consider the tax implications as these may be complex. You would have to declare any income and gains in the UK, although any tax paid abroad would be taken off your British tax bill. Inheritance can be particularly complex, too, so you might need to set up a local will as well as your will in Britain, or even invest through a special company.

Needless to say, you should seek advice from a lawyer. It might be best to use a specialist in Britain who understands the tax systems here and abroad, rather than a foreign lawyer, especially as foreign lawyers may not have professional indemnity insurance.

Other property tax schemes

You could instead set up your own business through the Close Trading Companies scheme in order to benefit from the business asset tax relief, especially the IHT exemption after two years.

Close helps you to set up small, asset-backed companies that qualify for the business asset tax relief rules. Eligible trades can include residential and commercial property development, as well as forestry and public houses. The key appeal here is that the company would not form part of your taxable estate, provided that you lived for at least two more years.

Higher-rate taxpayers can also claim 40 per cent income-tax relief by renovating flats above shops and offices. These properties must be no taller than five storeys (including the ground floor) and must have been built before 1980. Flats must be held for at least seven years in order to qualify, and the maximum rent is £480 a week in London or £300 elsewhere. You can also do this through a fund, the Coronation IV limited partnership, managed by property group Braemar, which requires a minimum investment of £25,000.

YOU CAN'T GIVE IT AWAY

From 6 April 2005, new rules have applied to a number of trust-based schemes designed to take homes outside estates. If you have 'given' your home to your children through a trust to avoid inheritance tax, and you continue to live in the property, the scheme will not work unless you pay rent or a tax charge, and your home will remain part of your taxable estate on death. The legislation was retrospective, covering trust arrangements that have been in place since 1986.

So if you have set up one of these schemes for your own home, you must now take action, depending on your circumstances. You have until 31 January 2007 to register to pay income tax on the notional market rent for your home (through the self-assessment tax form), or to pay a market-level rent to your children, which could land them with an income tax liability. If you do neither, your property will remain inside your estate.

The new charges may not have removed the attractions of these trust schemes, though. Nigel McTear, of independent financial adviser (IFA) Openwork, points out that the tax charge "can actually be palatable", compared with the alternative inheritance tax bill. For example, one of his elderly clients is paying £1,800 income tax a year in order to avoid a £140,000 inheritance tax charge on her home.

Mr McTear explains: "The thing about pre-owned asset tax is it gets more attractive if you're not going to have to pay it for very long." He says that the key factors are the rental value of a property and the owner's life expectancy. You also need to consider whether the tax charge could force you into the higher-rate tax band.

Source: PricewaterhouseCoopers. For a free pocket tax guide go to www.pwc.com/uk or call 020 7212 4999

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