Category Archives: Property

BTL Tax Changes Part I: How Does It Affect You?

BTL Tax Changes Are Here!

Osborne Wallpaper

Jimmy – S via Compfight

Tax. A small word, large implications. We all want to pay less of it, or avoid it. But, as my accountant likes to point out: Paying tax is good news, it means you are making a profit and doing something right.

However, the recent budget changes announced by George Osbourne changed the parameters of what constitutes taxable profit.

Up until last year, your taxable profit on residential buy-to-let was calculated as:

Taxable Profit = Gross Rent Received – Allowable Expenses – Mortgage Interest – Wear & Tear Allowance

The wear and tear allowance applied to properties that are let fully furnished.  For such properties, you could offset 10% of your rents received for that property to allow for depreciation (wear and tear) against your supplied furnishings. In properties with high rents, such as in London and the South East, this was a considerable allowance. This allowance has already been removed for 2016-17 tax year onwards.

Allowable expenses included items such as letting agency fees. Crucially, mortgage interest, usually an investors largest expense, was subtracted in full to arrive at the Taxable Profit.

Once you subtracted these from your gross rents, you paid tax on what was left, at your marginal rate (i.e. on top of any other earnings, such as a salary from your job).

Let’s take a simple example: You have a job, paying £55,000 per year. You have two BTL’s, grossing £15,000 in rent. Allowable expenses total £2,000 and you let both furnished, so you enjoy £1,500 (10% of gross rent) as a wear and tear allowance. Finally, your mortgage interest is £9,000 per year for both properties.

Currently, your taxable profit is worked out as:

Taxable Profit = £15,000 – £2,000 – £9,000 – £1,500 = £2,500

So you would pay tax at your marginal rate on £2,500. Given you are a higher rate payer (salary = £55,000), then you would pay £2,500 x 40% = £1,000 in tax on your buy to let business.

However, the budget of 2015 changed this significantly. It was announced that it was considered unfair that higher rate taxpayers were given mortgage interest rate relief at 40%, to the detriment of owner occupiers who didn’t get the same benefit. Therefore, starting from the 2017-18 tax year, the amount of interest rate relief would be reduced in stages, capped to a maximum of 20% by 2020, as follows:

  • 2017-18: Tax relief limited to 75% of mortgage interest costs
  • 2018-19: Tax relief limited to 50% of mortgage interest costs
  • 2019-20: Tax relief limited to 25% of mortgage interest costs
  • 2020-21 onwards: Tax relief limited to 20% (basic tax rate) of mortgage interest costs

Cue much gnashing of teeth by landlords, most of whom probably voted Conservative in the last General Election. There is plenty of discourse on various forums about these changes and the motivation, so I won’t go into them here. Suffice to say I think this is more of a governance issue than a revenue raising attempt, as regulating and taxing large players in the form of corporate entities is much easier than thousands of individual landlords.

As property investors, the key questions to understand the answers to are:

  1. How it affects your portfolio
  2. How does it affect your decision making going forward

In this blog post I will address the first question, with a follow-up blog post looking at the second question and help you understand if you should be adding another purchase to your portfolio and under what terms.

Redefining Taxable Profit

What makes this tax change particularly painful, is the way it is being calculated. Now, taxable profit will be calculated as:

Taxable Profit = Gross Rent Received – Allowable Expenses

There is a double whammy here. Mortgage interest is not discounted up front. In addition, another change announced in the budget was the removal of the wear and tear allowance.

Once the tax has been calculated at the marginal rate, only then can you offset a proportion of the mortgage interest, which by 2020 will be capped at 20%.

To take our example from above (salary of £55,000, two BTL properties grossing £15,000 in rent and £2,000 allowable expenses), then then taxable profit is:

Taxable Profit = £15,000 – £2,000 = £13,000

Quite a big difference from the taxable profit of £2,500 under the old rules!

You will now pay tax at your marginal rate on £13,000. With a salary of £55,000, this would be at 40%, i.e. £13,000 x 40% = £5,200.

By 2020, you will only be able to subtract 20% of your mortgage interest costs against this tax bill. With mortgage interest of £9,000, you would be able to claim £9,000 x 20% = £1,800 to offset your tax bill of £5,200. There is no longer any wear and tear allowance. This would result in a tax bill of £5,200 – £1,800 = £3,400. This is considerably more than the tax bill of £1,000 payable under the current rules.

Paying More In Tax Than You Actually Made In Net Profit!

One consequence of this is that, for highly geared and/or low profit landlords, it is entirely possible to have a tax bill greater than the actual net profit you are banking. Clearly, this can make such portfolios unsustainable unless you have other sources of income from which you can pay the increased tax.

If you are a lower rate taxpayer, whose combined property income and other income is below the higher rate tax threshold (which will be £45,000 for 2016-17 tax year), then there is no change to your tax position.

However, if you are a lower rate taxpayer in your day job, but by adding your property income you are taken into the higher rate band, then you will now pay 40% tax on some of your property income as you can no longer deduct mortgage interest before calculating your taxable profit.

BTL Tax Calculator

Notebook and calculator

Pixelmattic WordPress Agency via Compfight

In order to help you assess the impact to your own portfolio, I have put together a BTL Tax Calculator below.

To use it, all you need to know are the following input parameters:

  • Total Gross Rental Income across your portfolio, minus allowable expenses.
  • Total Mortgage Interest across your portfolio.
  • Total Other Income, e.g. your salary from your day job. If you are full-time landord, leave this as zero.

The BTL Tax Calculator will then work out your current tax position and the impact by the time the changes are fully phased in by 2020. It assumes that the tax bands will change as previously announced by the treasury, with the target for the 40% tax barrier expected to rise to £50,000.

As always, you need to think rationally and consider your own tax position before making any large scale decisions – it might not have as bad an impact as the wailing on the property forums would have you believe. If the tax bands rise as forecast, then it is perfectly possible to be paying LESS tax than currently, despite the changes to interest relief.

Disclaimer: Tax is a complicated business ... please seek professional advice before acting on any information given in the BTL Tax Calculator above!

What Can I Do?

If you find yourself facing a tax bill greater than your actual net profit by 2020, then you have some time to rectify the position. The options are:

  • Sell a property and use the proceeds to reduce your LTV on other properties in your portfolio. You can model this in the BTL Tax Calculator by reducing the Gross Rental Income and Mortgage Interest amounts for the property (or properties) you are considering selling.
  • Use other income or savings to reduce your LTV on properties in your portfolio. Again, you can model this in the BTL Tax Calculator by reducing the Total Mortgage Interest amount by the amount of interest you will save by paying down your mortgage(s). Note that most BTL lenders will allow you to overpay by at least 10% per year with no penalty, but check your terms and conditions to be sure. The amount of mortgage interest saved by overpaying can be worked out using the following formula:

Tax Interest Saved = Overpayment Amount x Mortgage Interest Rate

  • Increase the rental income. Rents, particularly in London and the South East, continue to rise. If you have long standing tenants who are still on the same rent when they took up residence, then it is possible they are now paying a rent less than the going market rent and there may be scope for an increase. However, you need to consider an increase against the backdrop of affordability for the tenants and the probability of them leaving your property as a result.  You can model this using the BTL Tax Calculator by increasing the Total Gross Rental Income figure by the annual amount any rent increases would result in.
  • Change the rental model. Do you have any family homes that might make good Houses in Multiple Occupation (HMO’s)? Such properties might yield a larger net cash flow than a single let, although this has to be balanced by the changes required to meet HMO regulations and possible licensing requirements, your local council’s regulations on amenity space, the extra management overhead required, the local demand for room lets, any mortgage restrictions (you may need an appropriate HMO mortgage) and the fact that is usual for the landlord to pay the costs of utilities and council tax. You can model this using the BTL Tax Calculator by adding the additional net rent to the Total Gross Rental Income figure.
  • Incorporation of your portfolio. Properties held within a Limited Company structure are still able to fully offset mortgage interest costs and pay corporation tax on the net profit. However, moving properties from your personal name into a limited company entity is classed as a sale and purchase. This means you may be subject to Capital Gains Tax on the sale of the property and the limited company will have to pay stamp duty on the purchase. In addition, limited company mortgages tend to have interest rates higher than BTL mortgages held in a personal name.. There is also the ‘known unknown’, of whether the current or future Chancellor of the Exchequer will turn his sights on such arrangements. I would suggest seeking specialist tax advice if considering going down this route.

Are These Changes a Good Thing?

On first glance, that seems like a stupid question.

With the additional tax burden, the removal of the wear and tear allowance and the recent introduction (as of 1st April 2016) of an additional 3% stamp duty surcharge on any second property purchase above £40,000 (so this would cover holiday homes for personal use, holiday lets and BTL purchases), it is clear that any property investor is facing strong headwinds moving forward.

But is it all doom and gloom? Remember, these are taxation changes. What does this mean for a property investor?

Consider the impact of these changes on the supply side of property rentals:

  • Likely reduced investment in BTL as such changes act as a deterrent and require more liquid cash to purchase (lower LTV to cover tax changes, increased capital required to afford the 3% stamp duty surcharge).
  • Some landlords will exit the market. Accidental landlords, or those highly leveraged with smaller cash flow will likely have to sell up if they face a tax bill greater than their net profit.

The net result: Less competition for new purchases and less competition for existing landlords as rental stock is reduced. Generally in any business, a reduction in competition is considered a good thing!

Now consider that the demand side for property rentals hasn’t changed. These are taxation changes imposed on landlords. There is the same tenant demand as before these changes, only going forward the supply of rental properties is likely to be reduced and the current rental stock also reduced. This increases pressure on rents and so we are likely to see increases in rents being achieved by landlords and more tenant choice for landlords.

For those landlords able to position themselves to absorb the changes, the future looks positive.

Let me know if you find the BTL Tax Calculator useful. If you have any suggestions for enhancements, let me know in the comments below.

Don’t let your friends and fellow landlords get caught out by these tax changes – share this calculator with them using the sharing icons below or directing them to this blogpost.

 

How To Make 68.45% Return On Investment On One Deal

We recently did a very quick buy to sell deal, using an unusual strategy: Buying through an estate agent and selling back through an auction. This isn’t an obvious strategy that naturally occurs to most property traders.

The property was a 2-bed flat, in a tired state of repair and a short (49 year) lease. It was on the open market with an estate agent in Cherryleas Drive, Leicester. It was brought to our attention by a local estate agent partner, who consistently sources promising deals for us. With a strong local sales market, this property was perfect for a buy to sell, our preferred strategy at the moment. Figure 1 shows the property. After some strong negotiation, we were able to secure it for £62,500.00.

Cherryleas Flat
Figure 1: Cherryleas Flat

When buying a property with the intention of selling on, you should always consider multiple exit strategies in order to protect yourself. The ultimate fallback position is to rent the property out.

But given a number of exit strategies, how do you assess the best route to take?

Do you look for maximum absolute profit?

Do you look for maximum return on investment?

What about risks?

The answer isn’t immediately obvious…

However, there are analytical techniques that help you determine the best relative route to take, which takes into account returns and risk.

Most property investors are comfortable with the definition of a return. In essence, this is the profit (or loss) on an investment, usually expressed as a percentage over a given period that the capital was invested.

The average investor concentrates overwhelmingly on the return, whilst neglecting the risks. A risk can be defined as the chance (or probability) of a given investments return being different than expected.

A fundamental concept in investing is the relationship between risk and return. Generally speaking, the higher the return then the greater the risk, since investors demand to be compensated for taking on the higher risk that the investment won’t actually deliver the higher return.

How can you evaluate the various risk / return rewards for a given property investment strategy?

One of the best decision making tools is the Expected Value concept…

This is a fundamental concept in probability. The Expected Value is the anticipated value for a given investment. It is calculated by multiplying each of the possible outcomes by the probability that each outcome will occur and then summing all those values.

This is best illustrated by an example. Let us consider standard roulette with 38 numbered slots. A straight bet on any single number will payout 35 to 1. So if you had £1, would you take that bet? You are making a judgment on whether your investment of £1 will return £35.

The answer should be no. This is because the Expected Value of that bet is:

EV(£1) = -£1 x (37/38) + £35 x (1/38) = -£0.05

This means that an investment of £1 will expect to lose 5p on average. This is not an investment you would want to make and is exactly why the casino wins in the long run.

Have you ever met a poor casino owner?

If we can make an educated reasoning, using our knowledge of the macro-economic picture for the property markets in which we operate, of the probability of various investment outcomes, then we are in a position to compute the Expected Value of a given property investment that has a range of outcomes.

But property trading usually involves expenses. You can choose to do a basic refurbishment, a full refurbishment, or none at all. In our case, the flat not only needed a refurbishment but also had a short lease. Is it worth extending the lease, or leaving it as is? Further, there are often finance or holding costs to consider, which are larger the longer you retain the property on your books, as would be the case in a full refurbishment or lease extension.

How do we pull all this information together when working out the Expected Value?

We simply leverage another analytical tool called the Decision Tree…

A Decision Tree is a tool that allows you to analyse and choose between several courses of action and form a balanced view of the relative risks and rewards between them.

It is in this way that we decided the best expected outcome for the sale of the purchased Cherryleas flat was in fact through auction.

Let’s consider the options we had:

  1. Perform a very light refurbishment, leave the lease as-is and sell on through an auction.
  2. Perform a full refurbishment, extend the lease and sell on through an estate agent.
  3. Perform a full refurbishment, extend the lease and remortgage to a sensible LTV and retain to let.

From a point of view of return on investment, we utilised a Decision Tree and Expected Values.

Let us consider one branch of this tree: Option A.

By considering market values and talking to local auctioneers on the strength of the auction rooms at the moment, we determined that a reasonable reserve value would be £74,000. We reasoned that we were 60% confident that the reserve would be achieved. In addition, we were 20% confident that we might achieve more than the reserve, with a likely top value of £78,000. We also had to consider the chance of the property not reaching the reserve, which we assigned a 20% chance of that happening.

So in summary:

  • 20% probability of achieving up to £78,000.
  • 60% probability of achieving the reserve of £74,000.
  • 20% probability of not making the reserve and failing to sell on the day.

Note the probabilities should sum to 100%.

What is the Expected Value of the auction sale?

This is calculated as:

EV(Auction Sale) = (0.2 x £78,000) + (0.6 x £74,000) + (0.2 x £0) = £60,000

Therefore, on average, we expect to return £60,000 on this property from an auction sale. Notice this isn’t an achievable value – if we don’t hit the reserve of £74,000 we won’t achieve any sale. It is an Expected Value of the investment, given the stated risks (probabilities) and returns (sales values).

Now we have expenses to consider. A very light refurbishment would be in order, consisting of redecorating and new carpets to freshen it up, but no work to the kitchen or bathroom. There are also auction fees, capital holding costs and so on. In total we would expect to spend £5,000.

Figure 2 shows an example room in the flat before refurb, Figure 3 shows the same room after redecoration and new carpets.

Cherryleas Flat Before Refurbishment
Figure 2: Cherryleas Flat room before a light refurbishment
Cherryleas Flat After Refurbishment
Figure 3: Cherryleas Flat room after refurbishment

Taking expenses into account, this means we can say that the benefit of selling at auction would realise £60,000 – £5,000, or £55,000.

Again, this is not an absolute realisable figure. It is the relative benefit of option A and can be compared with the other relative benefits of option B and C to determine the best option to take.

If we continue this analysis for all options, we get the following decision tree, shown in Figure 4.

 

Cherryleas Decision Tree
Figure 4: Cherryleas Decision Tree – click for a larger image

Note that the larger refurbishments needed in option B and C incur larger costs, reducing the expected net benefit of taking that option.

It is clear from this analysis that option A of selling through auction gives the largest relative expected benefit, so this is the option we chose.

And what of the outcome?

Well, the property went to auction and achieved a sales price of £77,500, right near the top of our market assessment, validating our decision.

You can see the result here

How we made such a good return

This property was part funded by a private investor, who wanted a good return on his money. This enabled us to buy with speed, a prerequisite in the current strong sellers market.

The headline figures are:

Revenues
Sale £77,500.00
Cost £62,500.00
Gross Profit £15,000.00
Expenses
Search fees £200.00
Insurance £134.50
Refurbishment £689.68
Legal Fees £1,570.20
Auction Fees £1,500.00
Investor Return £1,200.00
Net Profit £9,705.62

Because we have leveraged private investment capital, the returns on our own employed funds over the period of investment will be a very healthy 68.45%

How smart thinking helps avoid a catastrophic loss

Note that tools such as Decision Trees and Expected Returns need accurate market knowledge to provide sensible input values. We need strong local knowledge of market values, refurbishment costs and local demand in order to make informed decisions about expected end sale values. The Expected Value and Net Benefit is sensitive to the input values and assigned probabilities and so sufficient thought must be given to make these as accurate as possible.

The more astute of you will notice that if an auction sale returns a net benefit of £55,000, then with a purchase price of £62,500 we will, on average, lose £7,500, not unlike the casino roulette example mentioned above.

This would be correct if the £62,500 spent on the property was a true sunk cost. The beauty of property as an investment is that it retains an intrinsic value. Note that in this example, all options actually remain available. Should this flat not have met the reserve at auction, then we still own it and options B and C were still viable. We would have gone with the next best expected net benefit, option B. If we couldn’t achieve an expected asking price of £90,000, then option C was available to us.

Remember Expected Values are not necessarily realisable returns. In Option A, we would either return £74,000 or more (the property met or exceeded the reserve value), or we would have lost £5,000 (our sunk costs should the property not have met the reserve).

If, instead of property, the £62,500 was (e.g.) earmarked for investment into the development and marketing costs of a mobile phone app, with an expected net benefit of £60,000, then that is not an investment you would want to make. This is because the £62,500 invested is a sunk cost, lost forever should the mobile app not make the returns you expect.

This is a good example of limiting the downside and avoiding catastrophic financial disasters which wipe you out.

What decision making tools do you use when evaluating such deals? We would love to hear your thoughts in the comments below.

If you want to be considered for membership of the Tycoon Investment Club so that you can join like-minded private investors and earn enhanced returns on your money whilst also learning about how we structure deals like the Cherryleas flat, then send an email to support@tycoonsystem.com and we will be in touch.

Will an interest rate rise crash the property market?

For today’s blog post I will be looking at some UK related property market data to try to make some sense of what is going on at the moment and to plan intelligently going forward. This is a simplistic summary of a longer analysis that I will be doing this Saturday with the Tycoon Genius Partnership group.

Let’s start with the key factors that affect residential property prices:

  1. Supply of properties, existing stock as well as new.
  2. Demand, from existing population and those from outside the UK.
  3. Availability of finance and the cost of finance.
  4. Affordability, i.e. sufficient income to be able to afford finance payments or rent.
  5. Confidence among builders, lenders, home buyers, investors etc.

    1. Supply

In the UK, the supply of new build housing is largely controlled by a few large private developers (see chart below), unlike the system in Europe where most new residential housing is supplied by individuals building for themselves (more information here). The sharp drop off in local authority contribution to new housing is quite striking:

Local authority contribution to housing

Demand changes much more quickly than supply can adjust. For example, as the property market recovered from the 2008 crash, many builders struggled to scale up to meet demand. This was reflected in increased prices for materials, especially bricks which have a long production lead time and similarly, the availability of skilled labour was strained and remains so. Developers are also constrained by the planning system and the availability of finance. Having said that, developers are interested in maximising profit so they balance building just enough to maximise profit margins whilst avoiding cannibalising each other’s developments since building more properties than markets can absorb will depress prices. What developers really struggle with is planning permission, especially for green field land.

Thinking about supply in these terms helps me understand why more far fewer properties than we apparently need are getting built out.

2. Demand

According to a government study, the number of households is projected to grow by over 200,000 per year (this is the demand that soaks up the new mentioned in the last section) and interestingly from a landlord’s perspective, one person households are projected to equate to ⅔ of the increase in households. Population growth accounts for ¾ of the growth in households:

United kingdom population

Source:tradingeconomics.com

In nominal terms (i.e. without adjusting for inflation), UK house prices have risen 4x in just 22 years. That is almost twice the rate of increase that Spain and the USA experienced over the same period. Clearly, it has been a remarkable period in which to own real property in the UK:

House price index

Source: Economist.com

Help to buy has made it easier for people to buy newly built homes by reducing the level of capital input from the buyer. The important thing is that help to buy stimulated demand to help get the construction industry moving. This is crucial for confidence because so many people are employed in construction related industries which leads to knock on confidence effects (mentioned later) that stimulate the housing market further.

3. Availability and cost of finance

It seems plausible that if borrowing becomes cheaper, more people will borrow money and compete for a limited stock of assets. Asset prices should then rise in response, given that supply cannot be scaled up easily to meet demand and this is pretty much what we see happening:

Real house price vs interest rates

The chart shows there is some correlation between borrowing costs and property prices. It is hard to predict what will happen when rates rise because there hasn’t been an equivalent period in the recent past where interest rates have remained so low for so long, but going on what has happened before, it would seem likely to have a dampening effect should rates rise sufficiently.

Finance is loosening up as shown in the chart below. It is interesting to split this into finance for BTL investors and non investors and see just how much buy to let lending has risen since the crash (I’ll talk more about this on Saturday):

United Kingdom mortgage approvals

Source:tradingeconomics.com

4. Affordability

Mortgage payments as a percentage of take home pay is low at the moment because it is cheap to borrow:

Mortgage payments as percentage of income

Increases in borrowing costs as a result of an increase in interest rates will not affect everyone. Those with little debt will hardly notice. Some will worry how far they may rise in the future and for others with too much leverage it will hurt. If rates rise quickly, over leveraged property owners could panic and this is why the Bank of England has spent several years softening up the public about a future rate rise.

Were rates to shoot up as they did in the late 70’s, and early 90’s, this could spell disaster for many owner occupiers and landlords whose incomes may not stretch to meet all their commitments.

A small rise in interest rates won’t hurt many landlords, but it will naturally make them realise they can’t stay low forever. Most investors I meet have simply gotten used to them being low and this is very dangerous in my opinion. The removal of mortgage interest relief will further hurt those with significant debt to service.


After inflation, property in Britain has risen 2.5x since the early 90’s:

House prices in real terms

Source: Economist.com

However wages have risen much less:

Real wage growth in UK

Source goldmadesimplenews.com

According to the ft, the lack of wage growth is due to dismal productivity, which, it could be argued is a result of low wages but that’s for another discussion…

This huge rise in prices and meagre income growth help to explain why as a multiple of average income, property prices in the UK are now nearly 7x from a low of 2.5x during the early 90’s crash (100 on the chart below represents the long term average of about 4x). Against average income, property prices in Britain are way above the long term average, and are close to the levels seen at the height of the last boom:

Price against average income

Source: Economist.com

This is why young people cannot afford to buy a house on their own. They either share the burden with their partner who also needs to work, rent, or move in with parents.

5. Confidence

We do not read much in the papers about how ‘confidence’ affects asset prices because confidence cannot be easily measured, but just because you can’t easily measure something doesn’t mean it matters less than the things we can measure. I would argue that confidence matters a great deal.

People are more confident about property when prices have been going up in the recent past (e.g. 2006) than periods when prices have recently been falling (e.g. 2010). Exceptionally low interest rates have forced many investors to seek a home for their money, and many millions of pounds has flowed into residential property as a result. This creates a feedback loop: rising asset prices attract more investors who compete with each other for limited stock which causes asset prices to increase and so on..

We all feel more confident when we have a stable income. This matters because loans on property require stable long term streams of cashflow. Therefore, when people feel they have the ability to take on mortgages, they naturally compete for property and prices go up:

Unemployment vs property prices

Also notice the positive correlation between unemployment rates and property transactions:

Unemployment vs number of property transactions

People generally feel confident about the market at the moment, and judging by some of the behaviour I have observed in auction rooms, there is some overconfidence. As Warren Buffett famously says ‘Be Fearful When Others Are Greedy and Greedy When Others Are Fearful’.

Conclusion

So will an interest rate rise crash the market? Pundits will insist they know the answer, but I’m always suspicious when someone is convinced they have the right answer but he has not bet any money on it. You might look at the evidence in this blog post and decide (as I have) that UK property seems expensive.

The best we can do as investors is plan for the future. Should homeowners and investors lose confidence in the market, or there is some major shock to the system then prices could fall. This could present a buying opportunity for the prepared.

If you are coming along to our next Tycoon Genius Partnership meeting this Saturday I will be presenting my detailed findings and discuss further with the group.

Parmdeep Vadesha

P.S. I have not had the chance to list all my data sources, but if you want to know where I got any of the data from just drop me a line.