More than six years have passed since George Osborne announced landlords can no longer claim mortgage interest as a tax-deductible expense.

And from Jan 31st, 2022, the four-year phasing-in cycle and knock-on impact for tax payments on account will finally be complete. So with landlords almost over the hill of Osbourne’s Section 24 tax payment increases, will we now see an end to the trend of business restructuring?

Certainly, those sitting on the fence may well have decided that their property portfolio remains a good value investment as it is – even if they have extra tax to pay.

In particular – due to low borrowing costs and increasing rents, many landlords have better cashflow now, despite the tax changes. (For example, I recently looked at how one married couple refinanced their property portfolio to beat the tax changes.)

Of course, I write now after 12 years of record low and decreasing interest rates. But with inflation running above 4% – most landlords will feel that interest rates can only go one way from here.

SO WHAT HAPPENS IF AND WHEN MORTGAGE RATES RISE

Leaving the wider market impact to one side, how will it impact landlord cashflow?

Of course, if you have no mortgages, you won’t be directly impacted. So, the answer to this question really depends on a landlord’s personal situation.

The more leveraged you are, the more sensitive your portfolio will be to rising rates – depending on your rental yields and profit margins etc. To illustrate the potential challenge, we will look at one of the more severe (but not untypical) cases of a landlord partnership running at 75% loan to value.

Take a £4m portfolio with £3m in mortgages, a relatively healthy gross rental yield of six per cent with 20 per cent expenses and a mortgage rate of two per cent. Assume that the landlord is a full-time husband-and-wife partnership, the total post-tax income for the couple would be £92,344 – or a return of 9.2 percent on their £1m equity.

Should interest rates rise to 5.5 per cent (the minimum lenders must stress test at), then an additional £105,000 in annual mortgage expenses absolutely decimates the profitability of the portfolio, leaving our husband-and-wife team with just £8,344 to live on between them.

You can see how rising interest rates could really start to bite.

Table – Impact of Rising Rates & Section 24 on Post Tax Profits

Interest Rate Annual Interest ‘Real’ Profit Before Tax Taxable Profit Tax on Taxable Profit 20% Tax Deduction on Interest Tax to Pay After-Tax
Income
(Between 2)
2% £60,000 £132,000 £192,000 £51,656 £12,000 £39,656 £92,344
3.75% £112,500 £79,500 £192,000 £51,656 £22,500 £29,156 £50,344
5.5% £165,000 £27,000 £192,000 £51,656 £33,000 £18,656 £8,344
7.25% £217,500 -£25,500 £192,000 £51,656 £43,500 £8,156 -£33,656
Table above given £240,000 gross rental yield and £48,000 tax deductible expenses based on 2021/22 tax year

 

Of course, it might be argued that as long as wages and inflation follow suit, rising interest rates will be accompanied by rising rents. But that’s no guarantee.

And what’s worse, because of Section 24, landlords who are higher rate taxpayers will need to charge an extra £1.25 in rent for every extra £1 of mortgage interest – just to maintain the status-quo.

A NEED TO PAY DOWN DEBT

Whatever the interest rate, sitting on the fence will cost a similar amount in overpaid tax. But as interest rates rise, every lost penny counts for more – and a driving need to pay down debt may mean offloading properties with a sizeable gain. Outside a protective structure, that is yet another large tax bill to pay in 60 days.

In the worst cases, further property may need to be sold to cover the Capital Gains Tax bill. We call this the ‘CGT business death cycle’, and it is the topic of one of the videos in our free video vault for landlords. A scenario I do not wish upon any.

CGT SAVINGS ON A WELL-TIMED INCORPORATION

Perhaps counter-intuitively, for those that do intend to reduce debt on their portfolio by selling property in the coming decade, giving up tax-savings today and delaying a business restructure further might make sense.

This is because incorporating a business to a company or limited liability partnership can defer any gains made since acquiring the property from being taxed until you either a) dispose of your interest in the business, or b) die – at which point Inheritance Tax takes over (which can be planned for separately).

This means that property can be sold within the business and the gain taxed based on the value of the property at the date of incorporation, rather than the date of the original purchase.

Such a rebasing of assets could help reduce capital gains tax (CGT) to the absolute minimum for landlords that have the foresight to act sufficiently in advance – typically recommended to be at least 18-24 months or so before any sales.

BUSINESS STRUCTURE FLEXIBILITY

During lockdown, at the London Landlord Accreditation Scheme online conference on the pandemic, I referenced a sort of Occam’s razor for tax and business planning:

In an uncertain future, all else being equal, the most flexible option is best.”

It is partly for this reason that many of our clients make use of a limited liability partnership as the focal point of their business structure.

Due to the favourable tax laws on the treatment of capital and income in a partnership, this can allow the business to be highly tax efficient, whilst keeping on the table most other options should HMRC practice and legislation change in the future.

Indeed, our landlord couple sitting on the fence with their £4m portfolio could save £19,376 a year in unnecessary tax for their business.

Not only would this buy them time in the event rates rise, but the portfolio could be adapted over the coming years without Capital Gains Tax derailing their efforts.

With this in mind, you might expect the restructuring trend to continue for a good while to come.

If you want to find out if you could benefit from a business restructure, Less Tax 4 Landlords offer a free initial assessment of your circumstances which you can start by calling 0203 735 2940 or by clicking here to complete the initial assessment form online.

This post originally appeared in the NRLA December 2021 Bulletin. The full bulletin can be accessed by NRLA members at https://www.nrla.org.uk/news/monthly-bulletin/

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