The Pitfalls Of Too Much Buy To Let Borrowing

Selling up to deal with the fall-out from how mortgage interest tax relief changes impact their finances is a headache many property investors face with buy-to-let borrowing. 

The problem dates back to years when buy-to-let borrowing up to the hilt was encouraged to expand buy-to-let portfolios quickly, and the government allowed landlords to offset all their mortgage interest against rental income. 

But those days have gone, leaving many landlords holding investments that will struggle to wash their faces because they are highly leveraged, and a sale will come with a hefty capital gains tax bill.

The Osborne Tax

At the root of the problem is former Chancellor George Osborne limiting mortgage interest tax relief for higher rate taxpayers to 20%. Announced in 2017, the measure has been phased over several years and marks a significant turn in tax for landlords. 

Combined with a new format for working out taxable profits, the relief is an extra tax charge on landlords. Instead of working out tax based on rental income less the costs of running a property business, the Osborne Tax takes the turnover – the total income for the year – then deducts running costs without taking away mortgage interest. Instead, the taxable profit becomes the turnover less costs and a 20% tax credit based on mortgage interest paid. 

For example:

 Before Osborne TaxAfter Osborne Tax
Mortgage interest(£6,000)-
Running costs(£1,000)(£1,000)
Gross profit£5,000£11,000
Tax at 40%£2,000£4,400
Tax credit-(£1,200)
Tax due£2,000£3,200

The landlord tax trap sprung by Osborne

Many landlords are finding that the new tax calculation, which came into force on April 6, 2020, has left them paying much more tax than before. 

But worse for many is negative equity derived from a capital gains tax bill plus borrowings coming to more than the proceeds of a sale when they make the logical decision to cut their losses by selling. The problem often dates back to when investment property was refinanced without considering CGT. 

The buy-to-let business model was easy – purchase a property and take out an interest-only mortgage at the maximum loan-to-value. Then wait for the price to rise and take a further advance to fund the purchase of more property until borrowing was maxed out on the portfolio. 

For example, a buy-to-let was purchased for £100,000 on an £80,000 interest-only mortgage. A little later, the deal is refinanced with the home worth £200,000, making the mortgage £140,000. The funds go towards a deposit on another property. After more time, the property value rises to £300,000 and the mortgage is upped again to £240,000 to buy another property. Now, the owner wants to sell and settles for an offer of £285,000. The scenario is familiar. The tax trap is then sprung. As the investor is a higher rate taxpayer, the gain of £185,000 attracts a CGT rate of 28%, which adds up to £51,800. The CGT bill plus the outstanding loan comes to £291,800, and to seal the deal, the investor must put even more cash into the pot. This is a simplified account. 

The investor would have some costs to reclaim, and the CGT annual exempt amount to offset would reduce his CGT outlay a little. But the principle still holds good.

The solutions?

If a buy-to-let investor has a property not mortgaged up to the hilt, there are always solutions to the problem.

  • Refinancing a portfolio, so newer properties with more equity bring down the borrowing on those in the landlord tax trap.
  • Refinancing the investor’s primary home to bring down buy to let borrowing.
  • Switching the property to a holiday let to take advantage of the CGT entrepreneur’s relief reduces the CGT rate to 10%. This does mean meeting strict furnished holiday let rules for two years or more.
  • Considering a change in trading status to a company or limited partnership raises issues over stamp duty and other tax issues.

Although it’s easy to say in hindsight, the best option is never to leave an investment property without the equity to repay any mortgage plus CGT.

Buy to let borrowing pitfalls FAQ

Tax is often the last thought on a property investor’s mind when they are caught up in the excitement of building a buy-to-let portfolio. But ignoring the consequences has a nasty way of returning to bite you. Here are some answers to the most asked questions about buy-to-let tax.

What does loan-to-value mean?

Loan-to-value is the proportion of the value of a property you can borrow from a lender. Often expressed as LTV and a percentage – so 75% LTV means a lender will stake a mortgage of up to 75% of the property’s value.

What is entrepreneur’s relief?

Entrepreneur’s relief is now called business asset disposal relief and applies to business owners disposing of certain assets. The buy-to-let property does not qualify for the relief, but furnished holiday lets do. For investors, business asset disposal relief reduces the capital gains tax rate to 10%. 

More about business asset disposal relief

Does mortgage interest relief affect all property investors?

The relief impacts individuals with a residential property business, but not companies. Basic rate taxpayers (20%) are less affected because their tax credit remains the same, although how they compute their taxable profits changes. Higher rate taxpayers lose as their tax credit is cut by half from 40% to 20%. 

More about mortgage interest relief

When do mortgage interest relief tax changes start?

They are already underway. The start date was April 6, 2020, so next year’s self-assessment season (due on January 31, 2022) will mark the measure's first year.

What is equity in a property?

Equity is the proportion of the value of a property held by the owners. They have 100% equity in a property without any mortgage, which reduces to 25% with a 75% mortgage.

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