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How residential property is taxed

Robert Pullen of Blick Rothenberg explains the tax bills landlords can expect from HMRC
How residential property is taxed

The UK residential property sector has roughly the same value as all of the companies listed on the UK Stock Exchange combined. It is therefore one of the two major asset classes for investors. The market is diverse, with city apartments being the most favoured by passive investors due to the 'lock and leave' principle. In particular, 'buy-to-let' investments have become very popular, with most lenders now offering a buy-to-let mortgage package.

It's an investment that's suitable for investors who are prepared to tie money up in real UK property with no immediate access to it, other than rental income. The investment is illiquid and there are transactional costs on purchase and sale. Money can be raised by mortgage against the property, with the debt repaid out of rents. Individuals who relocate abroad benefit by being 'locked in' to the UK housing economy while living away, giving protection from UK house price inflation.

The majority of private investors hold either one or two properties in addition to their main home. A relatively new 'build-to-rent' principle is emerging where a wealthier landlord or syndicate, typically a company, will commission the construction of a block of apartments for the purpose of furnishing and immediate letting to the public.

With the availability of land at a premium and with housing in short supply landlords can play an important role in maintaining an active market for those who want to rent property.

However, recent UK tax policy has been designed to temper growth in the private rental sector through charging higher stamp duty land tax (SDLT) on acquisition and more than halving the income tax relief on landlords' bank borrowings. Further restrictions have been made to bring foreign-owned property within the scope of inheritance tax. Despite this, landlords still see the future of property investment as attractive, with the shortage of housing in the medium term supporting the trend of growth in rents.

People have been letting property for hundreds of years. Within the past 75 years rent controls have sought to protect tenants and deregulation has meant that landlords can take vacant possession easily. Under current assured shorthold tenancies, landlords may charge an open market rent as well as gain possession, usually within two years.

The UK housing stock is said to be collectively worth over £6 trillion, with over one quarter of that value accruing within the past three years alone. The majority of the 23m residential dwellings are in private owner-occupation, either as the main or second home, but growth in the private rented sector now means that around 20 per cent of the value of housing is owned by landlords. And that proportion is expected to grow, underpinned by increasing job mobility, the high transactional costs of ownership and lack of regional affordability for young homeowners.

The UK housing market is comparatively deregulated compared with other countries, allowing access to the private rental sector for most foreign nationals looking to inwardly invest, typically into cities such as London, Manchester and Birmingham. Growth in new housing numbers currently runs at approximately 0.7 per cent, or 175,000 new units a year against established targets of 220,000 a year, while planning approvals are currently around 240,000 new units a year. The average house price across the UK at February 2017 taken from the indices published by Nationwide, Halifax and HM Land Registry was £214,911, indicating an average rise of 5.1 per cent per year based on reported transactions. Sharp regional variations often make national average prices a relatively benign statistic - according to HM Land Registry, the average home in London sells at £484,000, compared with £167,000 in Aberdeen.



Stamp duty land tax

Once upon a time SDLT was simple. Until 6 April 2011, purchases of UK residential property incurred a maximum SDLT rate of 4 per cent. This was changed in the Finance Act 2010, which introduced a 5 per cent rate for purchases over £1,000,000 - but this rate was increased to 7 per cent within a year. This was the start of further changes, which have seen the SDLT 'take' for the Treasury increase from £7.4bn in 2005-06 to £10.7bn 10 years later.

The Finance Act 2012 dropped a bombshell, introducing a 15 per cent flat rate for UK residential property purchases of £2m or more by companies. While this would not affect most buy-to-let investors, by 2014 the threshold was reduced to £500,000.

The Autumn Statement 2014 introduced what is now the Stamp Duty Land Tax Act 2015, reforming the SDLT system for residential property to remove the controversial 'cliff-edge' or 'slab' system.

Those acquiring properties below £937,500 are now better off, but any purchases above this level pay more. The 'slab' system had been widely criticised, with property agents openly noting distortions in house prices at the various SDLT bands. The introduction of a progressive rate system was long overdue.

In April 2016, SDLT was again increased, with a 3 per cent supplementary rate added for an acquisition of an additional residential property. The rule is quite harsh, and catches an individual who has only a small interest in an existing property, via an inheritance for example. The rules soon generated an outcry from professionals and the public, which led to a number of revisions and alterations for 'granny-annexes', among others.

In Scotland, the tax is known as land and buildings transaction tax and is even more penal. The 10 per cent rate kicks in where a purchase is more than £325,000, while SDLT remains at 5 per cent until the price exceeds £925,000.


Income tax

Income tax is payable at an individual's marginal income tax rate. The rents can be reduced for tax purposes by allowable annual costs such as insurance, internal and external repairs, safety checks, letting agent's fees and mortgage interest. Replacement furniture can be deducted from the rents if a property is let furnished with a minimum quota of beds, tables, chairs, curtains, carpets and all white goods. HMRC has useful information on its website;

Under the current law, individual landlords can deduct mortgage interest to calculate their taxable rental profit. However, from 6 April 2017 mortgage interest relief will start to be restricted to basic rate (20 per cent) income tax gradually over the next three years:

■ Tax year 2017/18 - 75 per cent of mortgage interest will be fully allowable and the remaining 25 per cent available at the basic rate.

■ Tax year 2018/19 - 50 per cent of mortgage interest will be fully allowable and the remaining 50 per cent available at the basic rate.

■ Tax year 2019/20 - 25 per cent of mortgage interest will be fully allowable and the remaining 75 per cent available at the basic rate,

■ Tax year 2020/21 - mortgage interest deduction will only be given at the basic rate.

The mortgage interest relief restriction does not apply to properties qualifying as 'furnished holiday lets', commercial properties and companies.

When the new measure takes full effect, the interest cost will be completely disallowed in computing rental profits and instead a tax credit equal to 20 per cent of the interest will be given against an individual's income tax liability.

As the interest cost is completely disallowed, it means the individual will have higher overall taxable income. This could push an individual into a higher rate of income tax (40 per cent/45 per cent), reduce their personal allowance (if their income now starts to exceed £100,000), affect their entitlement to child benefit and restrict the amount on which they can claim tax relief for pensions.


How the new rules affect a landlord's income

John is employed and earns £80,000 in salary and bonuses per year. As well as his employment income, John owns a buy-to-let residential property from which he receives £40,000 a year. John has a mortgage on the property and pays £25,000 interest per year, so that his net rental profit before tax is £15,000. John's income tax position and net profit after tax over the next five years is shown in the table below:

John's net profit after tax
100 per cent75 per cent50 per cent25 per cent
Tax year2016/172017/182018/192019/202020/21
Employment Income80,00080,00080,00080,00080,000
Rental Income40,00040,00040,00040,00040,000
Loan Interest(25,000)(18,750)(12,500)(6,250)-
Net rental income35,00041,25047,50053,75060,000
Less: personal allowance(11,000)(10,375)(7,250)(4,125)(1,000)
Taxable income84,00090,875100,250109,625119,000
Income tax payable27,20029,95033,70037,45041,200
20% tax credit for interest cost-1,2502,5003,7505,000
Total income tax payable27,20028,70031,20033,70036,200
Net profit after tax9,0007,5005,0002,500-

John may expect that the new rules will restrict the tax relief on the mortgage interest to the basic rate, but because the mechanism operates to increase John's overall taxable income above £100,000, he starts to lose his personal allowance by £1 for every £2 of income over this threshold. By 2020-21, John's personal allowance is restricted to just £1,000, resulting in a £9,000 increase in his tax liability and reducing his net rental profit to nil.

Higher-rate and additional-rate taxpayers investing in residential property will need to consider the appropriate property ownership structure in light of the changes. A corporate structure may be more attractive, as the same restriction for mortgage interest will not apply to companies. In addition, the main rate of corporation tax will reduce to 17 per cent by 2020, further increasing the difference between corporate and personal tax rates. Whether a company is suitable will depend on the amount of SDLT the company will have to pay to acquire the properties, whether any capital gains tax is payable when the property is transferred to the company and whether borrowing has to be renegotiated.


Capital gains tax

The main rate of capital gains tax was reduced with effect from April 2016 to 20 per cent, but for residential property the previous 28 per cent rate was retained.

For let properties, there may be relief for previous periods of owner occupation and where the property was the owner's main residence for tax purposes at any time. In addition, a special 'letting relief' worth up to £40,000 may also be in point.

There is one exception to the 28 per cent rate and that applies where the property being disposed of is a qualifying furnished holiday letting that meets definitions contained within both the relevant tax acts. If the holiday letting business meets those definitions, holiday property sold may qualify for a lower 10 per cent capital gains tax rate.

The conditions are, broadly:

(1) The accommodation is available for commercial letting as holiday accommodation to the public generally for at least 210 days.

(2) The accommodation is commercially let as holiday accommodation to members of the public for at least 105 days (with no continuous occupation by the same holiday maker of more than 31 days).

(3) The business must be commercial, that is to say it must make a profit, year on year.

(4) The property must have been used as holiday accommodation throughout a period of at least one year up to the date the holiday business ceases.

There are more detailed rules outside the scope of this article, so professional advice should be sought.


Inheritance tax

UK residential property is expected to contribute over half of all UK inheritance tax receipts in 2017-18. The tax is charged at 40 per cent and the value of property left in deceased estates is expected to be worth in excess of £45bn, but outstanding mortgage debt and the inheritance tax nil-rate band worth £325,000 will reduce the eventual inheritance tax collected by HMRC.

A new 'main residence' nil-rate band worth £125,000 from April 2017 and gradually increasing to £175,000 from April 2020 means that individuals who own homes will eventually each have an inheritance tax exemption worth £500,000. This additional exemption was introduced to protect rising property values, particularly in southern England, from inheritance tax. Where a person downsizes from their main home and ploughs part of the proceeds into a buy-to-let, a second home or a home for their children or grandchildren to occupy, this additional band can still be claimed provided the second home (and other assets) passes to their direct descendants on death.

Another way in which to reduce the impact of inheritance tax is to make gifts of an interest in let property to younger generations. Capital gains tax has to be considered first because gifts other than between spouses and civil partners are chargeable to that tax if the property has increased in value and there is no SDLT on gifts of mortgage-free property.

Finally, a family can pull off the 'Duke of Westminster trick' and gradually transfer their property to a wide family discretionary trust. The assets remain under control of the donors, but after seven years the property portfolio is outside of the mainstream IHT rate of 40 per cent and is instead exposed to a charge of 6 per cent every 10 years, which can then be spread.

If that sounds too complicated, then life insurance could be considered.

There is always going to be demand for property. The UK remains a small island with high population density. Preserving and protecting areas of outstanding beauty and greenbelt between our towns and cities will provide challenges to how we build houses in the future. Space will have to be used more wisely, housing models may change, but housing numbers will increase. Tourism, industries, culture and our universities are a great magnet for visitors and a growing percentage of the population will look towards a competitive rental market to deliver housing needs. The long-term future looks bright for commercially astute landlords.


Robert Pullen is a senior manager at accounting, tax and advisory firm Blick Rothenburg