In my last article covering Investments, we explored some of the most commonly found assets on any astute personal balance sheet. Real Estate is something that always creeps up, either by default or design, and whilst there’s a lot of talk about this asset class, I’ve seen a noticeable behavioural change in recent years. You could argue that there are two things in life that human beings will always need; Food & Shelter, so its no wonder that some people swear by property as a life long investment, and perhaps they have a point.
However, its not all glamours and there is an element of romanticism that comes with being a Landlord, which would-be investors should be aware of. Becoming a Landlord is either an intentional decision you make, or it could be accidental. By accidental I mean those who inherit a property from family, or those who decide to buy a new home and are unable to sell their current one, so decide to rent it instead. You may be wondering why this matters, but if you fall into this category then its important you read on.
Mortgage Credit Directive Order ( MCD)
In 2015 the Financial Conduct Authority ( the Banking regulator) announced a new directive that would change the way Banks and Lenders approached Mortgage lending. The aim of this was to ensure the process of offering Mortgages was rigorous and offered more protection to the borrower. The introduction of MCD meant that Lenders were now obligated to:
1) Carry out affordability assessments
2) Provide a minimum level of advice
3) Offer disclosure by way of an illustration known as ( European Standard Information Sheet)
4) Provide ongoing training to staff.
5) Introduce regulation for Consumer Buy-To-Let.
Whilst most of the new rules were enhancements to what lenders already offered, the biggest change was the new directives covering Buy-To-Let borrowing. This meant those being considered as ‘Accidental Landlords’ would now receive regulated advice when taking out a Mortgage for their investment property. The official definition given by the FCA for those who this applies to is;
“ A buy-to-let mortgage contract which is not entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower.”
If the definition leaves you scratching your head, then perhaps the occasions that will make you exempt from this will offer a bit more clarity;
1) Uses the Mortgage to buy a property, intending to rent it out.
2) Has previously bought the property intending to let it out and neither they nor their relatives have lived there.
3) Already owns another property that has been let out on a rental basis.
There was a time when obtaining a Buy to Let Mortgages was simple, you only needed to prove that the gross rental income was sufficient to cover the servicing cost of the loan, including the ‘Stressed cost’. The Stressed cost is a mechanism used to assess your ability to afford your loan, should interest rates rise by say 3% above the rate you’re currently paying. Under this method of assessment the BTL market flourished, and those who could afford it literally filled their boots.
Most Buy To Let Mortgages are taken out on ‘Interest only’ arrangements, which mean they only pay the interest each month, and typically plan to sell the property at the end of the term to repay the capital. This further increased their profit margins as the monthly payments are usually only a fraction of the rent they receive. For example:
Property = Two bedroom flat which costs £400K,
Mortgage = £280K
Mortgage Interest Rate= 2.3%
Repayment type = Interest only
Monthly cost =£536.
If you charge £1500 per calendar month for this property you’ll receive £18K a year, and based on the above Mortgage calculation, your total Mortgage interest cost will be £6,440 a year. This means you’ll be making a profit of c.£964 after you’ve paid your mortgage every month. ( subject to any other upkeep/costs).
In addition to the ‘easier’ access to borrowing, owners were also able to maximise their profits by offsetting their entire mortgage interest costs against the tax due on the rental income. So in the example given, you would deduct the £6,440 from the £18,000 gross rent before paying tax.
One could argue that finding means of reducing any tax liability is prudent financial planning, and with a creative accountant there are no limits to what can be achieved. As the famous saying goes; ‘make hay whilst the sun shines’ and for a period of time, BTL owners were in a world of their own, capitalising on cheap mortgage debt and maximising their profits.
THE NEW ORDER
Following the introduction of the Mortgage Credit Directive, there was also an announcement about the change in tax rules, which meant that from 2020 onwards, landlords could no longer offset their Mortgage interest payments, but instead they would only quality for a 20% tax relief. This means that Landlord will now pay more tax on their income, but more worryingly those with low yields could now find themselves with very little or no profit going forward.
The Mortgage assessments would now be based on the Net rental income rather than Gross, and also include the borrowers wider commitments and liabilities.
This also came at a time when the Government introduced the additional Stamp Duty Charge for those buying second or subsequent properties, where an additional 3% was payable on top of current rates.
As a result of these new changes, 2017 became an uncomfortable year for those with large investment property portfolios. They faced the reality of reduced profits and increased acquisition costs, and the romance of being a Landlord was no more.
The immediate aftermath was people frantically looking for solutions on how they would manage their properties going forward. I remember at the time, there was wide spread concern that the property market would be flooded with supply as Landlords would be wanting to sell their low yielding stock, to relieve them of the impending burden.
THE FUTURE LANDLORD
If you were an accountant in 2017, you probably remember the increase in enquiries from clients looking for ways to circumnavigate the new rule. Ultimately the changes to the BTL tax treatment only applied to private and individual owners, so the ‘light bulb’ moment came once people realised they could put their properties in a company structure. A company is a separate legal entity and the interest costs will be considered as an ‘expense’ therefore deducted from the gross income before tax is due.
Additionally the company will pay Corporation Tax which at the time of writing is 19%, so considering that income tax for individuals can be as much as 45%, then this was the solution most people were looking for. If you’ve ever heard about the rise in people buying investment properties in Companies or Special Purpose Vehicles ( SPV), then this is the main reason why.
But there is further complication still, because the process of changing ownership from an individual to a company is considered a sale, and therefore Capital Gains Tax could be payable. Additionally you need to give consideration as to how you extract the income from the company ( salary or Dividends) as there will tax implications here too. However if you decide to sell the property at a later date, then there will be no Capital Gains Tax Payable, as this doesn’t apply to companies.
Having a company means you’re obligated to file annual returns & accounts with Companies House, which is additional admin and potentially additional costs if you need an accountant to help with the filing.
Now that you understand the new order of being a Landlord, the only thing left to consider is what to buy. The ultimate objective of owning a rental property is to achieve a good yield and hopefully Capital appreciation along the way. The type of property and the location you choose are crucial factors in achieving these objectives. The most common types of Investment properties are;
House with Multiple Occupants ( HMO)
Commercial ( Retail/Office)
Each of these will present individual opportunities as well as challenges in regards to the type of tenant you attract. During the Covid-19 out break the Government released new measures which meant that all Court evictions were put on hold until 23rd August 2020. During this time it was illegal for Landlords to harass tenants or lock them out of their homes if they were unable to pay rent. Clearly this wasn’t ideal for Landlords who still had Mortgage interest payments to cover.
The worst case scenario for any Landlord is a prolonged period of Void or having a sitting tenant who’s unable to pay rent. The latter causes even further complications as it’s extremely difficult to sell a property without vacant possession.
Despite all the recent changes, BTL’s are still considered to be a good asset, one that provide residual income and capital growth. However with the new Tax treatment, the way you own and operate your investment property is more important now that ever.