Why buy-to-let contractors must plan better
It was a no-brainer to us back in August that limited companies would come into their own for plenty more people than just contractors, thanks to a £60billion attack on the buy-to-let industry, writes Sat Singh, the chief executive of ContractorMoney.
What we didn’t quite work out is just how popular the ‘Ltd’ structure would become due to the attack, launched by George Osborne in his July Budget. Contractor-friendly lender Kent Reliance is probably surprised too.
Property purchases via ‘Ltds’ soar
It says that borrowing to pay for property through limited companies no less than trebled in September (compared to the previous year). This represents the biggest uptick the lender has ever seen in terms of borrowing to use a company vehicle to buy property, and it’s clear that shrewd contractors bypassing an imminent tax hike are largely behind the historical high.
Many contractors with a buy-to-let will be pleased they’ve acted in this way, as will landlords who weren’t already using an incorporated structure. Remember, both these investors have come under a two–fold attack by the chancellor. First, he hit them at the Summer Budget with plans to cut tax relief on mortgage interest to just 20% - prompting the dash towards ‘Ltds.’ Secondly, he used last month’s Autumn Statement to bring a hefty 3% levy on the stamp duty payable when a purchasing a property to let.
Angst in April?
This punitive levy is first of the changes to affect contractors, as it is due to bite from April 2016. It means contractors will pay the standard rate of stamp duty plus an additional 3% when purchasing a property. So a contractor purchasing a property for, say, £250,000 will see their stamp duty bill rise from £2,500 to £10,000! With the higher take on dividends due to bite from April as well, this fourfold increase could hardly have come at a worse time.
But while the news won’t put Osborne on any contractor’s Christmas card list, in the weeks since the levy was announced we’ve seen no detriment to the long term aspirations of contractors who want to both own and let out a property. Many suggest to us that they’ll simply look to any potential appreciation in property value to cover the increased cost of acquisition.
Tax relief cap on mortgage interest
The more significantly detrimental change for contractors is the planned reduction in tax relief on mortgage interest, which will be phased in between 2017 and 2020.
Let’s recap. Contractors currently receive full tax relief on their mortgage interest payments, effectively allowing them to offset the full cost of their mortgage against their rental income before calculating their taxable profit which is then taxed at the contractor’s highest marginal rate of income tax.
The planned change will see the tax on profit stay. However only basic rate tax relief will be received on the mortgage interest. A higher rate tax payer will have to pay the difference – a further 20% tax – on the interest payments relating to their mortgage. The impact will be profound. Given a typical scenario – annual rental income of £12,000 and mortgage interest payment of £9,600 – a contractor would expect to yield a profit of £2,400 from their buy-to-let, creating a tax liability of £960 if paying higher rate tax. Well from 2017 that same contractor will have to pay a further £1,920 in tax, or 20% of the mortgage interest, pushing their payment to the exchequer up to £2,880 for the year. This outstrips the profit made and leaves the contractor with residual loss.
And although there still remains the opportunity for capital appreciation, contractors are likely to find the prospect of running an investment at a loss a somewhat unattractive one!
The contractor’s best friend
Yet contractors needn’t put their aspirations on hold. Since the summer, we have been working with providers to build a solution for contractors come 2017/2020 and, as mentioned at this piece’s outset; the limited company takes centre stage.
Put simply, incorporating allows contractors to ring-fence their rental income, in much the same way that a Personal Service Company does for contracting income, and avoids the reductions in tax relief on mortgage interest which were announced by the chancellor this summer.
Limited company buy-to-lets fell out of favour with permies during the credit crunch, partly as many of them didn’t really understand the benefits of an incorporated structure. However contractors have continued to use these vehicles to reduce the tax they pay on their rental profits. Now there’s the added benefit of retaining full relief on mortgage interest.
Getting started on limited company BTL
Far from a preserve of the PSC contractor, this route should appeal to anyone affected by the chancellor's proposed change – that’s anyone who is currently (or intends to be) receiving an income up to the higher rate tax threshold (rental income included).
Before getting started there are critical choices to make ahead of picking a provider. Crucially, most limited company buy-to-lets require a completely separate limited company, wholly owned by the contractor.
This requires the deposit for the purchase of the property to come from the contractor’s own funds. If you currently retain those funds in your limited company, you’d have to draw and pay tax on a dividend to cover the amount. For many contractors this proves rather punitive. The average deposit on a buy-to-let for a contractor is £62,500 and would create a significant tax bill – not what you want when you’re already facing a 3% hike in stamp duty.
Fret not though, because there’s a solution via us and the largest provider of limited company buy-to-lets which allows the property to be owned by a wholly owned subsidiary of your contracting company. This not only allows contractors to benefit from the relief on mortgage interest, but also allows the deposit funds to be transferred in a manner which creates no further tax liability. In a nutshell, it reduces the costs of both funding and running the buy-to-let.
Think harder, plan better
Getting your buy-to-let right the first time is by far the best option. As a result, contractors should now think more carefully – and plan more effectively - than ever before about taking the conventional buy-to-let route. While existing properties can also be incorporated these will need to be ‘purchased’ by the limited company at full market value, creating a potential stamp duty and capital gains tax liability. Tax reforms loom large and the need for professional advice to maximise your returns will be ever present in the years to come.