by Rob Dix
We’ll start with the very basics of record keeping and your obligations to the tax man. Then we’ll take what seems like a detour into a very specific aspect of property taxation – but it actually sets the stage for the discussion of a common question: “Should I invest in my own name or through a limited company?”
After that we’ll get into the expenses you can offset against tax, then put together everything we’ve covered to see how you can end up with a lower tax bill than you might have suspected. Psyched? I knew you would be!
Obligations and basics
Once you’ve bought a property in your own name, it’s your responsibility to tell HMRC that they now have another method by which they can gouge money out of you. They’ve got no way of automatically knowing, which is great until they catch up with you a few years later and take action against you for tax evasion.
If you already fill in a tax return, all you need to do is fill in an extra page for your new property income. But if you’re currently taxed via your employer, you need to notify HMRC of your need to complete a tax return. The easiest way is to call them using the details on their website.
Filling in that tax return used to be pretty straightforward: take the rental income, deduct all the allowable costs you incurred (which we’ll come to), and whatever’s left over is your profit. That profit is split between any joint owners, and it’s added to your other sources of income when calculating the tax you owe. Now, as a result of the changes to the treatment of mortgage interest that take effect from April 2017, it’s going to be more complicated to work out your tax position for the next few years – as we’ll see in the next section.
Alternatively, if you buy a property within a company rather than in your own name, that company will need to file accounts. Then, when you draw profits out of the company, you’ll be in exactly the same position as above: you’ll either declare that income on your tax return if you already complete one, or let HMRC know that you now need to.
In terms of record keeping, everything becomes a lot easier if you have a separate bank account that’s used solely for property transactions. Any normal current account will do: just have the rent as the only payment coming in, and expenses going out as direct debits or charged to the associated debit card. If you have a linked savings account, you can also get in the habit of regularly transferring funds across to cover tax and/or serve as a contingency fund. Whether you do the bookkeeping yourself or let your accountant handle it, it’s a lot easier when the transactions are separated rather than intermingled with your own finances.
Speaking of which, do you need an accountant? When you’re just starting out, not necessarily: if the sums are small, it’s unlikely that an accountant will be able to save you more than they’re costing you (as long as you get yourself clued up about what you can claim). But if you’re lacking in confidence or time, there’s no reason not to get help.
If you do choose to get help from an accountant, it’s best if you use a property specialist – ideally someone who’s also a property investor. Personally I use the accountant who does the books for my business because I consider myself to be on top of the property side of things, but if I wasn’t so involved I’d definitely want to have a specialist on my team.
Property traders
If you’re trading in property rather than investing, you get an easier ride through the rest of this chapter: you get to sit out the discussion on mortgage interest, the debate about whether to incorporate, and the distinction between “capital” versus “revenue” expenses.
What I mean by “trading” is that you’re buying a property and selling it on again without renting it out in the meantime. In this scenario, you’ll usually be better off buying within a company rather than as an individual (although be sure to check with an accountant first). Doing so means you’ll pay corporation tax rather than income tax on your profits, which is significant for higher rate and additional rate taxpayers. Even basic rate taxpayers can come out ahead with a company through techniques like moving your “year end” date to minimise liabilities, which isn’t possible for individuals. (An accountant can help with minimising any tax liabilities when extracting profits from a company, if you don’t intend to let them build up within the company for future purchases.)
With corporate structure established, the accounting process of a property trader is straightforward: when you sell a property you can deduct all the costs you incurred along the way (everything from the finance arrangement fee at the start to the estate agent’s fee at the end), and what’s left over is subject to corporation tax.
That’s not to say that there isn’t more for traders to be aware of than is covered in this book. For now, I just want to give you enough information so that you can factor in the impact of tax on your trading business. Any further knowledge you gain from talking to an expert will have the potential to save you a lot of money.
The great mortgage interest fiasco
The chancellor of the exchequer isn’t going to win many popularity contests at the best of times, but in the summer of 2015 George Osborne announced a change that prompted a spike in Amazon sales of voodoo dolls (I imagine) among property investors.
Before getting into the details, it’s important to be clear that this only affects individual property investors: the treatment of property within companies is the same as it was before. That’s why I’m talking about this first, and then getting into the debate about whether you should incorporate – because it has a major effect on everything that follows.
So what is this change, and why is it so universally loathed and protested against? It all revolves around how mortgage interest payments are treated in your property accounts.
Previously, property investment income would be treated in the same way as any other business: rent comes in, expenses go out, profit is what remains – and that profit is taxed. If you take out a mortgage to acquire a buy-to-let property, the monthly interest payments are considered to be a cost of doing business – and therefore they’re deducted along with all your other costs before calculating the profit that’s left over.
To put that into numbers:
£10,000 rental income
£5,000 mortgage interest costs
£1,000 other costs
= £4,000 profit
That £4,000 profit would be subject to your normal rate of tax – currently 20% for a basic rate taxpayer (meaning a tax bill of £800) and 40% for a higher rate taxpayer (meaning a tax bill of £1,600).
Here’s the change: from April 2017, mortgage interest can no longer be deducted as a cost of doing business. Instead of deducting it before arriving at your profit figure, you first calculate your profit and then claim a basic rate allowance (currently 20%) for your mortgage interest before calculating the tax due.
This becomes a lot clearer with the help of an example:
£10,000 rental income
[£5,000 mortgage interest costs – NOT DEDUCTED]
£1,000 other costs
= £9,000 profit
Allowance to apply: 20% of £5,000 interest costs = £1,000
A 20% taxpayer would therefore owe £1,800 in tax on their profit (20% of £9,000), then claim the allowance of £1,000, leaving them with a final tax bill of £800. A 40% taxpayer would owe £3,600 in tax on their profit (40% of £9,000), then claim the allowance of £1,000, leaving them with a final tax bill of £2,600.
Two things happen as a result of this change.
The basic rate taxpayer appears to end up paying the same amount, so let’s first take the case of a higher rate taxpayer. Clearly they have a higher tax bill, which was exactly the point of this new method. The intention is to “level the playing field” between owner-occupiers who can’t offset their interest against tax and property investors who can, but to limit that effect to higher rate taxpayers (who I presume they think can afford it).
Investors are up in arms about the principle of the change, because the financing costs associated
with acquiring capital assets is an allowable expense for every other type of business. (And because this new method doesn’t apply to properties owned within a company, it’s also an allowable expense for participants in the same industry if they have a different corporate structure.) But worse than the principle is the reality that if a higher rate taxpayer is highly leveraged, they can end up paying more in tax than they make in profit.
For example:
A property worth £200,000 with a mortgage of 80% of its value (£160,000) at an interest rate of 5%
£12,000 rental income
[£8,000 mortgage interest costs - NOT DEDUCTED]
£1,500 other costs
= £10,500 profit
Allowance to apply: 20% of £8,000 interest costs = £1,600
So the amount of actual cash that the investor has in their pocket after paying all their expenses is £2,500 (£12,000 - £8,000 - £1,500). Previously this would have resulted in a tax bill of £1,000 (40% of £2,500) and a post-tax profit of £1,500.
But their tax bill is now calculated as 40% of £10,500 (£4,200), minus the £1,600 allowance. That leaves them with a tax bill of £2,600 – which means they’re now making a £100 loss!
Bad news, then, for higher rate taxpayers. But did you catch the other thing that happened? Because profit is now calculated before interest is deducted or allowances are claimed, everyone’s income now appears to be higher. That means that a lot of investors who were previously basic rate taxpayers are going to be pulled into the higher bracket – even if their portfolio is barely profitable.
To complicate matters further, the new method is being phased in gradually from April 2017 and doesn’t come into effect fully until April 2020. From April 2017 the new method applies to 25% of your interest cost, then it’s 50% from April 2018, and 75% from April 2019 before it reaches 100% in April 2020.
For a few years it’s going to be really bloody complicated to work out how much tax you’ll end up paying – so I’ve just decided to imagine that the new method is fully in use right now when assessing deals.
Chances are, you’re now asking yourself a very good question: if the new method is worse and it only applies to individual investors, is it better to buy properties within the structure of a company?
Should you incorporate?
As this book is targeted at newcomers and I don’t want to over-complicate matters, I’m only going to talk about how to structure the purchase of properties you buy from now on. For the subject of whether it’s a good idea to move properties you already own into a company, I’ve put together a free course on The Property Hub (thepropertyhub.net/courses).
My stock answer to the question of whether you should incorporate used to be “Probably not, if you’re investing rather than trading”. Traders, as I explained earlier, are usually better off buying within a company. As an investor though, it often wasn’t worth it. Although you paid corporation tax at 20% rather than income tax at up to 45%, there were equivalent disadvantages (which we’ll come to shortly), which balanced things out.
But The Great Tax Shock Of 2015 changed all that, and there are now two big advantages to investing through a company:
You swerve the new treatment of mortgage interest, allowing you to deduct it in full before calculating your profit. (Although, note of caution: for now. If enough investors flee to companies, there’s nothing to stop the government dreaming up a new tax that will nullify the benefit.)
Your profits are subject to corporation tax rather than income tax, which will make a significant difference if you’re a higher rate taxpayer.
So far, so good. But there are drawbacks too:
If you want to draw profits out of the company to spend, you’ll do so in the form of dividends and be taxed for doing so – meaning that as a higher rate taxpayer you could end up no further ahead than if you’d just bought in your own name and paid income tax.
For example, a £1,000 profit taxed at an income tax rate of 40% leaves you with £600. A £1,000 profit taxed at a corporation tax rate of 20% leaves you with £800 – but you then pay a dividend tax rate of 32.5% (after the first £5,000 of dividends, which are tax-free) when you want to access the £800, leaving you with £540. So in this scenario, assuming you’ve used your dividend allowance, you end up worse off than you would have been by just paying income tax in the first place.
If you’ve been renting out a property for a while and then choose to sell it, as an individual you can use your annual capital gains tax (CGT) allowance so you’re not taxed on the full amount of the gain. A company doesn’t have a CGT allowance, so would end up paying more tax than an individual when selling the property.
Another disadvantage – although one that is improving rapidly – is that the number of lenders willing to lend to companies is more limited than it is for individuals. This tends to mean higher interest rates, lower loan-to-value ratios and higher arrangement fees. Even so, you might end up with a mortgage that’s a bit more expensive but end up saving a lot of tax as a result – so you need to run your own personal numbers.
Because dramatically more investors have started using corporate vehicles over the last year or two, lenders have responded accordingly and introduced more products with improved rates. This is only going to continue – so a good mortgage adviser to guide you through the options will be, as always, your best friend.
So should you incorporate? As a very general rule of thumb (which definitely doesn’t constitute tax advice), investors tend to find it advantageous to buy within a company if they plan to leave the profits to build up within the company for future purchases until (for example) they quit full-time work and their tax position changes. If they plan to withdraw the profits as personal income, it’s far more of a toss-up and it could well be better not to incorporate.
Again, I remind you that this is nothing more than a brief summary from a non-expert: weighing up the pros and cons and applying them to your own present situation and long-term goals is no easy matter. The right decision will depend on your current earnings, what you plan to do with the profits, what the future tax position of your portfolio is likely to be, whether you’ll be selling properties, how much leverage you use, and many, many other factors.
In short, it’s something you should take professional advice about rather than rely solely on a book. If this all sounds scary enough to put you off investing altogether, do reserve judgement until you’ve read the section on losses and tax planning in a moment – because the situation might not be as grim as it first appears.
Allowable expenses
If you’ve been glassily turning the pages through this section while your mind drifts off to the football or the Great British Bake Off, COME BACK! We’ve very nearly finished talking about tax, but it’s really important that we cover this next section before we can move on to something more exciting (which is pretty much almost anything).
In the course of running your property business you’ll incur expenses, and many of those expenses can be deducted from your income before arriving at your profit. The name of the game, then, is to make sure you claim every expense that you legitimately can: if you’re paying tax on your profits at a rate of 40%, remembering to claim an extra £100 in expenses will reduce your tax bill by £40. Clearly it makes no sense to incur expenses for the sake of it, but you should get the most out of the expenses you can’t avoid… and even be a bit strategic about it to extract maximum benefit.
Expenses fall into two different categories: capital expenditure, and revenue expenditure.
Capital expenditure relates to the costs of acquiring assets (in our case, that means properties), and costs relating to anything you do with that asset to materially increase its value. Examples would include:
The actual purchase price of the property.
Your legal fees for arranging the purchase.
Any refurbishment work you do to a property before letting it out for the first time (this becomes important in the next secti
on).
Any work you do to the property that improves it – and thus could increase its value. For example, converting the loft or adding an en suite bathroom.
Capital expenditure can’t be deducted from your profits in the year in which you incur the expense. Instead, you can only reclaim these costs when you eventually sell the property.
For example, if you buy a property for £100,000, pay £2,000 in legal fees and immediately spend £50,000 refurbishing it, that’s £152,000 in capital expenditure. If you sell the property for £300,000 in the future, you can deduct that £152,000 before calculating the CGT you will owe.
Expenses categorised as “capital” are no fun. You’re shelling out now and getting nothing back for potentially decades – and by the time you can reclaim them, inflation means that the relief you’re getting will be worth less to you than you paid out in the first place.
Everything that doesn’t fall under the category of capital expenditure is automatically revenue expenditure instead. Revenue expenditure is much more like it: you incur a cost today, and can immediately offset it against your income. Examples include:
Any fees you’re charged by a letting agent.
Any bills you pay as part of the rent.
Any repairs you need to make to the property.
Any furniture you buy for the property.
Any refurbishment you do after the property has already been let out, which broadly just restores it to its previous condition rather than makes an improvement. For example, redecorating, or replacing a dated bathroom suite with a new one that looks more modern but isn’t “better” in terms of its facilities.
In addition to these pretty obvious revenue expenses relating to specific properties, there’s a range of more general expenses that also fall under the “revenue” category:
