Broadly speaking, when a property is let out, costs incurred in the running of the property, as a going concern, can be fully offset against the income generated. This would include agent’s fees, insurance premiums, some maintenance, and, for now, mortgage interest.
However the Government is proposing to restrict the tax relief on mortgage interest payments for all landlords to the basic rate of income tax (20%). The restriction will be introduced in stages over four years, starting from April 2017.
Having introduced “right to buy” where Government homes were sold to the occupiers, and the recently proposed (and contentious) measures to force social housing organisations to do the same, this would seem to be a ‘backdoor’ approach to penalise non-owner occupiers, including private landlords.
In many cases, the effect will be to turn a poor net income yield, into a poorer one still; possibly even to a loss making situation the three examples below assume the following:
- Property value of £200,000
- Tax rate of 40% (though rates can be as high as 60%)
- A 50% mortgage (then 75%)
- A 6% gross rental yield (i.e. £12,000 per annum, but also 5%
- A mortgage interest rate of 4% (then 5.5%, closer to a long-term average)
- No allowance for other costs (e.g. management fees) has been included
Each example shows the yield net of income taxes before and after, as well as how much worse the position will be when the new rules take full effect.
Case 1 – 50% mortgage, 6% gross rent, 4% mortgage interest, net yield: 2.0%
| Property value | £ 200,000 |
| Individual tax rate | 40% |
| Rent per month | £ 1,000 |
| Mortgage value | £ 100,000 |
| Mortgage interest | 4.00% |
| Mortgage payment per month | £ 333 |
| Rent per annum | £ 12,000 |
| Current net profit per annum | £ 8,000 |
| After tax per annum | £ 4,800 |
| Future net return | £ 4,000 |
| Reduction in income | -£ 800 |
Case 2 – 75% mortgage, 5% gross rent, 4% mortgage interest, net yield: 0.6%
| Property value | £ 200,000 |
| Individual tax rate | 40% |
| Rent per month | £ 833 |
| Mortgage value | £ 150,000 |
| Mortgage interest | 4.00% |
| Mortgage payment per month | £ 500 |
| Rent per annum | £ 10,000 |
| Current net profit per annum | £ 4,000 |
| After tax per annum | £ 2,400 |
| Future net return | £ 1,200 |
| Reduction in income | -£ 1,200 |
Case 3 – 75% mortgage, 5% gross rent, 5.5% mortgage interest, net yield: -0.3%
| Property value | £ 200,000 |
| Individual tax rate | 40% |
| Rent per month | £ 833 |
| Mortgage value | £ 150,000 |
| Mortgage interest | 5.50% |
| Mortgage payment per month | £ 688 |
| Rent per annum | £ 10,000 |
| Current net profit per annum | £ 1,750 |
| After tax per annum | £ 1,050 |
| Future net return | -£ 600 |
| Reduction in income | -£ 1,650 |
Capital Gains
On one hand there will be other costs, reducing yield further, and I know I have not considered the implication of capital gains tax (CGT).
CGT is interesting as it has become a tax on inflation in many respects; house price growth is the last five years has been around 20% compound, or just under 4% per annum. Prices (measured as RPI) have increased 16% compound, a higher rate tax payer selling an investment property after this five year period pays 28% (after an £11,100 personal allowance) on the whole 20% gain, even though they’ve returned less than 1% per annum in inflation adjusted terms!
Conclusions
I understand the emotional attachment to bricks and mortar, particularly in contrast to very low yielding (but secure) cash returns, and the apparent volatility of equities; an investment strategy should be balanced, and whilst property may form a small part of an appropriate portfolio these proposed changes, particularly for higher rate tax payers (or greater) will further reduce the feasibility of a property-led investment strategy.
Diversification is not just for investment reasons: when the government change legislation as fundamental as this on a whim it makes sense to ‘legislatively’ diversify too: pensions, ISAs (cash and investment) and other tax previldged investments should invariably considered as part of a broad tax, investment and financial plan.
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