Jeremy Leaf

Has the Summer Budget busted buy-to-let? George Osborne’s changes to mortgage interest relief and tax could have a serious effect on the market, says Jeremy Leaf.

George Osborne imageBoth the restriction of mortgage interest relief for landlords to the basic rate of tax and the replacement of the automatic 10 per cent “wear and tear” allowance introduced in the Summer Budget could actually result in higher rents for tenants and lower profits for landlords!

Jeremy Leaf image
Jeremy Leaf

The Bank of England’s recent warning of the dangers to the wider economy of an overheating buy-to-let market may have been misplaced. From April 2017, full tax relief will start to be removed from mortgage interest so that by 2020, landlords will be able to offset payments only at the basic rate of tax (currently 20 per cent) rather than at up to 45 per cent, irrespective of their tax bracket.

A higher-rate taxpayer buying a typical one bedroom flat locally now, for say, £300,000 with a 35 per cent deposit and 5 per cent yield should generate £3,000 profit this year – or none at all by 2020 when the change becomes fully operational.

If landlords leave the sector, don’t develop their portfolio or replace lost profits by raising rents, supply is likely to fall.

Apparently, nearly 30 per cent or 1.7m properties in the private rented sector have been purchased with buy-to-let mortgages but it is those of higher value owned by higher rate tax paying investors will suffer most.

Mortgages remain the most significant outgoing for landlords who apparently spend an average of 28 per cent of rental income on repayments.

Landlords will no longer be able to rely on automatic tax relief on furnishings, appliances and contents either, but will have to provide evidence of actual expenditure or replacement from April next year, if the consultation which ends next October confirms the change. The new rules will apply to all letting properties irrespective of whether offered partly or fully furnished although holiday lettings won’t be included.

Is it fair?

Climbing the property ladder imageI’m not convinced that the additional burden on landlords was necessary or justified, as buy-to-let investors are already taxed more heavily than owner-occupiers. Addressing the overall shortage of affordable homes to rent as well as to buy, is a much more important issue, in my view.

Building more houses; making better use of existing resources, easing planning restrictions and maintaining responsible landlord and business lending – these measures are more likely to keep prices down – or at least stop them rising as quickly.

If landlords choose to leave the sector, don’t increase stock and/or try to make up for lost profits by raising rents, supply is likely to fall further adding to the upward pressure on rents.

Although rent increases tend to be limited by local market forces and earnings, even a modest uplift will make deposit saving and purchasing significantly more difficult for first time buyers.

Some ”accidental” landlords and those considering leaving the sector anyway will probably decide to sell.

Of just as much concern to landlords will be the long-predicted rise in interest rates probably before the end of 2015, as recently signaled by the Governor of the Bank of England, Mark Carney.

Prospective investors will inevitably consider the decision to enter buy-to-let more carefully, particularly if using the proceeds of a pension pot following the relaxation of these rules last Spring.

The key to improving longer term supply and quality more quickly in the private rented sector is probably to concentrate on raising the amount of institutional investment.

For those staying in the sector, lenders may tighten lending rules for investors as a response to reduced profitability. For example, landlords must ensure that the rent they collect covers at least 125 per cent of mortgage payments at present, but lenders will probably seek a bigger margin as risk for landlords is assessed differently than for owner occupiers.

How could landlords respond?

Re-mortgaging under a fixed rate loan now for say, five years, will provide some protection against increasing borrowing costs and help reduce shortfalls as a result of the tax changes and likely interest rate rises.

All or part of profits from rental income may be assigned to a spouse if not working or taxed at a lower level, so that their personal allowance, due to rise to £12,500 by 2020 or the 20 per cent tax band, can be utilised.

Higher rate taxpayers could cut tax bills by placing their property in a limited company, especially as corporation tax is due to fall to 19 per cent in 2017 and 18 per cent in 2020.

All costs can be offset against rental income in a company with profits payable as dividends. From April 2016, directors can receive up to £5,000 tax free every year. Dividends are then reduced by 32.5 per cent while basic rate taxpayers pay a 7.5 per cent dividend tax.

Independent professional advice is paramount to be aware of entry/exit costs and, for instance, lender appetite to offer buy-to-let mortgages on the same terms.

Other factors

Yields in some areas, including parts of London, have already fallen to almost uneconomic levels so investors have been buying more for capital growth than steady income in recent months. In future, though, landlords may seek better returns further away from London in places like Manchester which offer the best yields in the country, at present, according to HSBC.

Our more successful investors regard buy-to-let as a business and take a longer term view of their involvement in the sector, but liquidating assets may not be so easy for others bearing in mind the average length of time it takes to complete a sale.

Landlords have to allow for empty periods, rent arrears, expected as well as unexpected repairs and, of course, Capital Gains tax  when selling.

Actually, the future is bright

However, I doubt if the changes will dampen buy-to-let demand significantly as there may not have been a better time to invest because:

  • Rents are at a record high and have been rising faster than house prices,
  • Buy-to-let borrowing rates are almost at their lowest ever as there is a shortage of most types of rental property whereas mortgage products are plentiful.
  • Tenant demand is still buoyant with aspiring first time buyers finding it difficult to save deposits, afford higher loan-to-value mortgage payments, or both.

Yes, the future looks bright. It was recently predicted by PWC that those currently renting (7.2 million) will overtake those with a mortgage (8 million) no later than 2025 as the growth in home ownership since 1945 has gone into reverse.

The respected business consultancy went on to say that house price rises of around 5 per cent each year i.e. faster than earnings, difficulties raising deposits, a shortage of affordable homes and constrained social housing supply will swell ‘generation rent’ so that 25 per cent of all households will be renting privately by 2025 compared with around 18 per cent today and just 10 per cent 2001. Over 50 per cent of 20-39 year olds will be living in the sector by 2025 too as higher prices restrict access to the property ladder while more over 60s will be renting and for longer.

Although first time buyer numbers rose in 2014 to just over 300,000, the figure is still well below the half a million a year previously regarded as ‘normal’.

The effect on agency profits

Agents will need to be even more aware of the quality of their service to clients as the line between profit and loss narrows. An agent’s input will be particularly valued when it comes to advising landlords, for instance, whether rents can be increased without risking the loss of reliable tenants!

There’s no doubt the market will become much more challenging over the next year or so as landlords and tenants adjust to the new environment and these changes start to have an impact but the buy-to-let will still provide sufficient returns for many.

Jeremy Leaf is a former chairman of the Royal Institution of Chartered Surveyors.

Buy-to-let changes:

After 6th April 2017, profits from rents must be calculated without including interest payments. A new tax reduction will apply under the codes ITTOIA 2005, s 272A.

Companies are not affected by these new tax rules. The changes will be phased in over four years Landlords need to take advice from specialist accountants!

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