Buying a second property to let, or in some cases simply for investment, is a popular form of long-term investment particularly in a time when interest rates are relatively low. The property produces a rental income stream and in a buoyant property market there is likely to be capital growth from rising house prices. The popularity of buy to let initially caused a shortage of property and inflated property prices but increased building and renovation of flats reversed this trend with resulting over-supply, falling prices and rental returns. This article looks at some tax and financial planning considerations of buying a second property and highlights some of the potential problems which investors may face.
Tax and Financial Planning Considerations: CGT Exemptions
Nearly everyone is entitled to a capital gains tax (CGT) annual exemption (£10,100 for 2010–11), which means that no tax is payable on gains up to that amount each year. Spouses and civil partners are entitled to an annual exemption, so for jointly held assets there is scope for exempting £20,200 worth of gains in 2010–11. However, it is worth remembering that the annual exemption is good only for the current tax year – it’s a ‘use it or lose it’ relief. If you’re planning to make a series of disposals, you may want to consider the timing of sales between two or more tax years to use up as much and as many annual exemptions as possible.
Joint Ownership
Owning property jointly, or in the name of a lower earning taxpayer if there is a differential in tax rates between the two taxpayers, is good tax planning. Remember, though, to make sure that any gifts of capital to finance a deposit are outright gifts with no strings attached.
Long-Term Growth
Falling annuity rates make long-term investment in property an attractive alternative to pension contributions. Check with your financial adviser before taking any action.
Low Interest Rates
Low interest rates may make the returns available from renting attractive, particularly where the property does not have to be financed by a mortgage.
A recent upsurge in the purchase of buy to let property in some areas has depressed the rental market, so research prior to purchasing is vital. In some cases the investor will be dependent on capital growth to make a suitable return.
Potential Problems
There are of course various potential pitfalls in buying a rental property, which need careful consideration before making such a large investment. Some of the areas to watch out for include:
· Property prices may fall. Whilst the property is being let the capital value will not be an issue, but if the property needs to be sold, a fall in value may be a potential problem.
· Stamp duty land tax costs (SDLT), particularly in London and the South East, make frequent sales and purchases of property expensive. SDLT is basically a tax that is paid on legal transactions. It is currently paid on property costing more than £125,000 and there is no escape from it. The amount of duty payable depends on the purchase price of the property.
Current rates are as follows:
Purchase price Stamp duty rate
Up to £125,000 0%
£125,001 to £250,000 1%
£250,001 to £500,000 3%
Over £500,000 4%
Note that from 6 April 2011, an additional rate of SDLT is being introduced of 5% on residential properties costing £1 million or more.
· The economics of the investment depends on how much money is put down as a deposit and how much is borrowed. In addition, the owner will need to consider the cash-flow consequences. See the example below.
· Any money used to fund a deposit on a second property will be tied up in the property on a long-term basis.
· There are many costs associated with renting a second property including agents and management fees, insurance, ground rent and on-going repairs and maintenance charges. Remember that if an agent quotes a management fee of 15%, VAT will be added on top, making the actual fee payable significantly more expensive.
· It may be difficult to find a tenant. Research suggests that landlords can expect the property to be vacant for at least one month a year - even in a good year. Moreover, the larger the landlord’s property portfolio, the more likely this is to happen. Anyone considering purchasing a second property should ensure that they have enough disposable income to cover mortgage payments and other expenses during a vacant period.
· If interest rates rise the mortgage payments may exceed the rental income. Again, anyone considering purchasing a second property will need to ensure that they have enough disposable income to cover increased mortgage payments.
· Losses are not usually available to offset against the landlord’s total income, but they can be carried forward against future rental income.
· Under the self-assessment tax system, an individual in receipt of rental income must retain all their tax records for five years and ten months (broadly six years) following the end of the tax year in which letting commenced.
Example
James, who is a higher rate (40%) taxpayer, is considering buying a second property to rent out. The property price is £100,000 and he can afford to put down a deposit of £25,000, the remaining £75,000 being funded by a buy-to-let mortgage. He expects to earn £950 per month from renting the property.
The interest on the mortgage is £400 per month and the capital repayments over 15 years are £420 per month. Agents’ fees are 15% plus VAT and the other running expenses are expected to be £75 per month.
James’s monthly income will be as follows:
£ £
Rental income 950.00
Less:
Mortgage interest 400.00
Agents fees 167.00
Other expenses 75.00 (642.00)
Taxable income (3.7%) 308.00
Tax due at 40% 123.00
Net income 185.00
Lost interest on deposit of £25,000 (say) 115.00
Profit after tax and interest 70.00
Capital repayment 420.00
Net monthly cash outlay (350.00)
This example clearly shows that although James will make a profit of £185 per month (£2,220 a year) after tax, if he also takes into consideration the interest he will lose on his capital tied up in the deposit on the property, the profit is reduced to just £70 per month (£840 a year). If James takes into account the capital repayments, he will have to finance a net cash outflow of £350 per month, even if the property is let.
To make this investment more attractive, James needs to have spare cash available each month and be confident that the value of the property will increase by at least the interest rate each year. He will also need to take into account the costs of acquiring and selling the property.
Practical Tip
The rental income less the allowable expenses is subject to income tax. If there is a mortgage on the property the interest will in most circumstances be an allowable deduction. Depending on the interest rates and the rental pattern, there may be little tax to pay.
When the property is sold, if it is a second property, any gain will be subject to CGT. If the taxpayer has lived in the property as his or her principal private residence prior to renting or does so before sale, some or all of the gain may be tax-free.
By Sarah Laing
