Multi-property landlords: How not to become ‘property rich and tax poor’

Meg Saksida warns of traps to avoid when amassing a property portfolio. 

Prior to 2016, residential landlords had it easy when it came to UK tax. They could offset mortgage interest even if they were higher or additional rate taxpayers. There was also a 10% wear and tear allowance for furnished property (even if no expenses had been incurred), and purchasing properties incurred stamp duty land tax (SDLT) at normal rates.  

Furthermore, landlords could remortgage their properties standing at a value in excess of the mortgage and could use this equity as a deposit for another property. A large property portfolio could, therefore, be amassed reasonably quickly with the profits from the rental business paying off the mortgages over time and the mortgage interest being offset against the landlord’s rental income at higher and additional rates; a ‘win-win’ situation. 

The turning point 

In 2016, the substitution of the 10% wear and tear allowance with the replacement of domestic items relief and the 3% SDLT surcharge for those purchasing second or subsequent residential properties were both introduced. In 2017, the process of restricting tax relief for mortgage interest on residential properties to the basic rate commenced. 

The restriction of interest was brought in gradually from the tax year 2017/18 to 2020/21 and is fully integrated now. This means no individuals who are residential landlords can get anything other than basic rate relief on mortgage interest paid on a rental property. The replacement of domestic items relief does not allow the initial purchase of furniture, furnishings, household appliances and kitchenware, just the replacement of these items. In addition, where the landlord already has one residential property, SDLT can be as much as 15% on a property purchase. 

A collective groan was heard amongst the landlords of Great Britain! 

It is not difficult to imagine these landlords having had a long hard think during the last five years on whether it has been worth retaining their rental portfolio. However, with the rise in property prices being dismally slow (i.e., as low as 2.5% and 2.2% in 2018 and 2019 respectively) and then the impact of Covid-19 in 2020 and 2021 with all the financial instability that the pandemic caused, those landlords would have been forgiven for making the decision to wait until the market perked up. In addition, without an adequate rise in the property market, the equity trap may have occurred. 

The equity trap 

Landlords must always consider not only the strategic reasons for disposing of a property inside their portfolio, but also for any capital gains tax (CGT) which might have arisen on the gain above the historical cost over the years of ownership.  

In some cases, particularly where an equity release and remortgage have occurred, this tax (at 28% for higher and additional taxpayers) may mean that portfolio landlords become ‘property rich, but tax poor’, with not enough liquid funds generated out of a property sale to pay the CGT thereon. 

Example: The equity trap 

Lucy, an additional rate taxpayer, wanted to get herself a property portfolio, so in 1996 she purchased a two-bedroom flat in Cambridge for £90,000. She paid a £10,000 deposit and took out a mortgage on the outstanding balance. The flat was worth £200,000 in 2009, so Lucy remortgaged the property and used the equity to fund a 20% deposit on a three-bedroom house in Cambridge worth £550,000, the £440,000 balance being financed on a mortgage.  

By 2015, the two-bedroom flat was worth £270,000, and the three-bedroom property had increased in value to £600,000, so she remortgaged both the properties to purchase a block of five flats for £1,500,000. By this time, her relationship with the bank manager was such that she was able to negotiate a 15% deposit, equity releasing the maximum from the two-bedroom flat of £80,000 and £145,000 from the three-bedroom house. 

With only a small increase in value, in 2022 the properties were worth as follows: 

Although Lucy has a portfolio worth £2,710,000, in which there is £580,000 equity, if she decides to sell the two-bedroom flat, she would not have enough equity in the property to cover the CGT liability. 

Her CGT calculation would be: 

If Lucy sells the property for £280,000 and pays off the mortgage of £270,000, she will only have £10,000 in cash with which to pay the CGT of £49,756. She would be £39,756 short. She could find the cash from her own savings sources if she had any; but if not, she would need to think about selling the three-bedroom house to obtain the funds to pay the CGT.  

However, if she disposes of this house, she will also have a CGT liability as follows: 

If Lucy sells the three-bedroom property for £630,000 and pays off the mortgage of £585,000, she will have £45,000 in liquid funds. Although this is enough to pay the CGT arising on this disposal, there is still not enough equity to pay the CGT on the two-bedroom flat, and Lucy will be £17,156 short (i.e., £45,000 - £22,400 - £39,756). 

This is the ‘equity trap’.  

Incorporation? 

An alternative option may be to incorporate the business. With lower tax rates, the ability to offset mortgage interest, lower tax rates on gains and the ability to part dispose, this may be tempting.  

However, a company simply holding a portfolio of property is unlikely to be ‘trading’; as such, CGT business asset disposal relief and IHT business property relief are unlikely to be available. Furthermore, there will probably be a capital gain charged on the landlord at the point of the incorporation, as incorporation relief (which defers the gain to the company once the shares are eventually sold) is only available for a ‘business’; however, a collection of rental properties does not generally constitute a business. In addition, there would be an SDLT charge with the 3% supplement for a corporate purchase and extracting the taxed profits would cost even more to the shareholder.  

On balance, incorporation is really only suitable for those who feel the SDLT is worth the future benefits, have no capital gain (or small gains covered by the annual exempt amount) and who wish, moving forward, to build up rental profits in the company rather than extracting them. 

Happy days? 

The more the property market rises, the less the equity trap occurs. For the first time since 2016/17, the UK housing market has reached double figures at 10% (between January and November 2020).  

However, there is no reason to allow the tax tail to wag the investment dog. Each landlord will need to look at the pros and cons of retaining the business or selling the property on the facts of their situation.  

Practical tip 

Remember: CGT for residential properties needs to be paid and the return reported to HMRC by 60 days after the date of the property’s completion. Making sure there is enough equity inside the portfolio to pay any CGT that may arise at all times means the equity trap is avoided.