Chapter 11

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Residential Property

Bricks and mortar

‘Don’t wait to buy land, buy land and wait.’

Will Rogers

If you own your house, you are materially exposed to residential property. The vast majority of most people’s wealth is tied up in their house. Owning a house is not solely an investment. It has numerous non-monetary rewards, such as shelter and safety for you and your loved ones. It is much more than numbers and financial planning.

Investing in residential property is different from other investments for three main reasons:

1. We are all investors in residential property, either as owners or tenants. We simply need to live somewhere.
2. Residential-property investing falls outside financial market investments held in pensions, ISAs or bank accounts. It is an alien world with different rules.
3. Mortgage financing for residential property facilitates leverage.

This chapter is dedicated to residential property. The focus is on two broad topics:

1. owning your main home
2. buy-to-let.

This book does not aspire to be a guide to property investing – there are numerous dedicated guides and publications on this subject. Rather it will look at the main considerations when investing in property, with a particular emphasis on its role in long-term saving for retirement.

Owning your house

Should you buy or rent?

Buying your house is a huge commitment. It is expensive. You need to commit time and energy to maintaining it. Maintenance costs can be high. Mortgage financing can be risky. You give up flexibility since you cannot relocate as easily as when renting. Property’s value can fall. Buying may be more expensive than renting. It is not for everyone.¹

However, owning a house has advantages. You will have a place to live – a roof over your head, before and after retirement. When retiring, you might struggle finding income to pay rent. Owning your house allows you to live rent-free.

Over the long term, UK residential property tends to outpace inflation, appreciating in value. The British population increases, as is the demand for properties, whilst supply in prime locations is restricted. Price appreciation, of course, depends on location, location, location.

Try jumping onto the property ladder as soon as possible. It might be more difficult to do so in the future.

Figure 11.1 shows the UK average house price since January 1991. Over nearly 25 years the average house price appreciated by about 270%.

Note, however, that from 1991 to 1996 and from the end of 2007 to 2013 house prices fell or moved sideways. Like other investments, residential property can go through years of falling or flat prices.

Your house is a way to accumulate wealth and cash . The simplest way is after retirement, when the children have left home, to downsize by selling it and buying a smaller house.

Another way to access the equity in your home when you are over 55 is equity release. One type of equity release is a lifetime mortgage. This is a mortgage on your home but, instead of making repayments whilst you are alive, your estate repays the capital and interest when you die or you do so when moving a house.

A home reversion is another equity release product, where you sell your home or part of it to a provider for a lump sum or regular payments. You can live in your home for the rest of your life, as long as you maintain and insure it.

You can raise cash at relatively attractive borrowing costs on your owned house by re-mortgaging it (homeowner loan). If your house is worth £200,000, for example, you can take a £10,000 mortgage to buy a new car. You can then repay the loan over a number of years.

Interest rates on mortgages are typically lower than those on personal and credit card loans since mortgages are safer for lenders. Your house is the collateral (security). The principle of high risk, high return works the opposite way. When borrowing money, the lower the risk for the lender, the lower the rates demanded to compensate for risk. This is a basic principle of banking and credit.

Buying your house with a mortgage is akin to disciplined saving. Investments in your house can potentially increase its value and improve your quality of life. Rent payments are not saving since you buy a perishable service (housing) without accumulating ownership. On the other hand, your monthly mortgage repayments accrue ownership.

Each mortgage payment in a capital and interest mortgage (repayment mortgage) consists of capital repayment and interest. The capital repayment is saving as you increase ownership in your house (equity) over time, reducing the outstanding mortgage (debt).

Mortgage payments are not as tax efficient as is a pension since they do not benefit from a tax relief. You also cannot deduct them as expenses for tax purposes. But they are tax efficient because you are usually exempt from CGT on your house.²

Your house’s potential price appreciation and other financial and non-financial benefits of home ownership can make it worthwhile.

Mortgages

Whilst properties are relatively expensive, leverage makes it feasible for some long-term savers to buy residential properties.

Leverage is buying property with borrowed money. For example, you want to buy a property for £200,000. You saved £50,000 for a down payment (deposit) and borrow £150,000 with a mortgage at a 3% annual interest. Assume the property’s price appreciates by 8%. Your net profit is £16,000 − £4,500 = £11,500, a 23% return on your investment.^3,4

One advantage of residential property is that leverage is relatively easy to accommodate because of mortgages. Mortgage is a legal agreement between you, the borrower, and a lender, usually a bank or a building society. You receive a loan from the lender to buy the property. You promise to repay the loan with interest. Your property is the collateral for the loan.

The lender takes title to your property with the condition that the title’s conveyance becomes void when you repay your debt. That is, if you do not repay your mortgage, the bank can repossess your property.

Organising a mortgage is relatively simple. Most steps are completed online and via the phone. Facilitating leverage in your pensions and ISAs, on the contrary, might be impossible. Residential property allows leveraging yourself. But do so prudently.

Importantly, do not take a mortgage but plan a mortgage. It must fit your needs and circumstances.

Mortgage features

When choosing a mortgage, consider its rate, costs and features. Different mortgages come with different terms and conditions.⁵ Choosing the right mortgage is an important decision. If unsure, take professional advice.

According to rules from 2014, lenders and brokers must offer advice by recommending the most suitable mortgage for you. If you are uncertain about the advice, seek a second opinion. Use the ample sources of free mortgage advice.

How much can you borrow?

Buying a property is an immense monetary commitment; probably the largest you have made. You need to save for a deposit and borrow the reminder of the agreed price.⁶ The deposit and amount you can borrow minus the costs determine the budget for purchasing the property.⁷ Then, ensure you can afford it – you need sufficient income to pay the ongoing mortgage payments, including a sensitivity analysis in case the mortgage rate changes.

The amount you can borrow depends on several factors. Namely, the mortgage’s purpose (main home, additional property or buy-to-let); what you plan to do with the loan (first-time buyer, move house, re-mortgage, borrow more); mortgage’s term (normally up to 25 years); property’s location; your income (normally, lenders lend up to 4 or even 4.75 times your annual salary); your outgoings (expenses); your credit score; and loan-to-value (LTV) ratio.⁸

LTV is the ratio between the loan and property’s price. For example, if you borrow £150,000 to buy a £200,000 property, LTV is 75%.⁹ The higher the LTV, the riskier is the mortgage for the lender.

Use a free online mortgage calculator. After entering your basic information it calculates how much you can borrow, which mortgage deals are available for you and your monthly payments.

Rates

One of the most important factors when choosing a mortgage is its interest rate. It depends on current market conditions and the risk to the lender based on assessing your capacity to repay the loan. The assessment considers the LTV, the property, your finances and the mortgage’s characteristics.

Types of mortgages

Mortgages come with different rates and features, each with pros and cons.

Variable rate mortgages’ rates are – you guessed it, variable, changing based on a formula. A tracker mortgage tracks the BOE’s base rate plus a spread. If the base rate increases you pay more, if it decreases you pay less.

For example, 2% spread above the base rate when it is 1% means a 3% rate. After an initial period, ordinarily two to five years, the spread can significantly rise. If you want out before the initial period finishes, you might pay a penalty.

Lifetime or term trackers have no initial period. You have flexibility to early repay and terminate the mortgage when you wish.

The advantage of trackers is that rates tend to be initially lower than those of fixed-rate mortgages. Rates are transparent since they are linked to the base rate. Lifetime and term trackers offer valuable flexibility of early repayment and switching (re-mortgaging) without penalties.

The disadvantage is interest rate risk. Ensure that you can absorb higher rates. Otherwise, unable to make the mortgage payments, you might lose your property. Most mortgage calculators can calculate monthly payments for different interest rates.¹⁰

Another type of variable mortgage is a discount mortgage. Discount mortgages do not track the base rate but the lender’s standard variable rate (SVR). The discount applies to the initial period and then, normally, the rate moves to the much higher SVR. The lender can change the SVR independently of the base rate – SVR can even increase when the base rate decreases.

The advantage is potentially lower rates than fixed-rate mortgages. The disadvantage is rates are not as transparent as those of trackers.

Fixed-rate mortgages offer a fixed rate for the deal’s initial period, usually one to five years. Typically, mortgages come with an initial rate during the initial period, afterwards it jumps significantly higher. During the initial period, early repayment charges are imposed if you want to switch mortgages.

The advantage of fixed rate is that payments remain constant when interest rates rise. The disadvantages are that fixed rates may be higher than current variable rates and you are locked in the mortgage for the initial period. Exiting before involves a penalty.

A fixed-rate mortgage is like selling a bond. When interest rates rise, you benefit since your loan is worth less, as it is more competitive. When interest rates fall, you are worse off since your loan is worth more. When inflation increases, you benefit since it erodes the loan’s value. The opposite occurs when inflation drops.

Your fixed-rate mortgage is a liability (like a short bond) you can hedge by buying gilts with similar maturity to that of the mortgage. The values of the mortgage and gilts should move in the opposite directions when interest rates change.

Table 11.1 shows the monthly payments for different interest rates and repayment periods (terms) on £100,000.

This is an example of a simple sensitivity analysis to gauge whether you can withstand an increase in interest rates on a variable mortgage. Use such calculations to compare fixed and variable mortgages.

The choice of mortgages depends on your outlook on rates. If you expect rates to rise, a fixed-rate mortgage can be beneficial. It matters when rates will rise since, in the meantime, you might pay more on a fixed mortgage. If you expect rates to remain low, a variable-rate mortgage can be advantageous.

Table 11.1 Monthly payments for mortgage rates and repayment periods

Payments (£)	2%	3%	4%	5%	6%
10 years	928	977	1,027	1,079	1,132
15 years	649	698	750	803	858
20 years	510	560	613	669	727
25 years	427	479	533	591	652

Source: Mortgage calculator of BBC Homes

Check the spread between fixed and variable-rate mortgages. Wide spread (fixed above variable) means the lender expects rates to rise. Narrow spread implies the lender expects rates to remain stable or decline.

Offset mortgages offset your savings held with the lender against the mortgage so you pay less interest. For example, with a £150,000 mortgage and £70,000 savings with the lender, you pay interest only on £80,000. However, monthly payments include repayments on the full amount, so you repay your mortgage earlier, reducing interest payments.

The advantages are earlier repayment, flexibility of accessing your savings and, potentially, a significant tax advantage. Normally, you pay income tax on interest on savings. Offsetting the interest on the mortgage is tax efficient since you earn no interest and pay no tax.

With an offset mortgage you retain full control of your savings. You do not need a cashback facility.

The disadvantage of offset is that rates might be higher than those of other mortgages. Whether it is worthy depends on the savings amount you deposit with the lender. It needs to be sufficiently large to justify higher rates. If you are a high-rate taxpayer and cannot put more money in ISAs and pensions, an offset mortgage can be useful to reduce tax.

An offset mortgage can be used to save money for a deposit for buying another property, whilst reducing interest payments on your existing mortgage.

Fees and costs

Mortgages typically come with fees and costs, beyond interest payments. The provider charges an arrangement fee (product fee or completion fee) for the product. It normally ranges between nil and £2,000.

A booking fee may be charged when applying for a mortgage and might be non-refundable, even if the mortgage falls through. It can be up to £250.

A valuation fee is paid for surveyors to evaluate the property. A basic valuation report costs between £150 and £1,500, depending on the property’s value. Lenders usually require a valuation report. It is designed to assess the property’s reasonable price, considering any needs for repairs and replacements.

However, you may get your own surveyor or pay extra to the lender’s surveyor to check not only the value of the property, but also its state. You can choose between a Homebuyer Survey and a more comprehensive Full Building Survey.

These surveys provide details on construction, condition, needed repairs and matters requiring further investigation. The full report is usually recommended if the property is in bad shape or you are concerned about subsidence, for example. A Homebuilder Survey is suggested to ensure you are buying a property without any obvious skeletons in the closet. When buying an expensive property, it is wise to spend some more on an appropriate survey to mitigate risks.

Buying a property with hidden defect is a low probability high impact risk. The survey’s cost to mitigate the risk is worthwhile. Say the probability of serious defect is 2% and the cost of fixing it is £100,000. The expected loss is 2% × £100,000 = £2,000 which is more than the survey’s cost.

Most lenders require you to insure the property during the mortgage’s term. Obligatory insurance usually covers only the building, but some lenders insist on content insurance as well.

These are the main charges, but others may exist. Add all the charges to the mortgage’s total costs. Sometimes, you can borrow and defer charges (including stamp duty) by adding them to the mortgage. Whether it is profitable depends on whether you have cash, the time value of money and your opportunity cost – how much money you can make on the money whilst having it.

Early repayments

Flexibility to make early repayments is an option. Options in finance, and generally in life, are valuable. You never know when flexibility will come in handy.

Early repayment allows you to repay your mortgage and re-mortgage to another one, if you find a better deal, or reduce or terminate it, if you accumulate cash. For example, if you receive a bonus or an inheritance.

However, it is not always sensible to early repay, even when cash is available. It depends on the opportunity cost and potential returns on the cash.

For example, your outstanding mortgage is £150,000; its rate is 3% without penalties for early repayment. You win £150,000 in the lottery. One possibility is paying off your mortgage, saving 3% interest payments or £4,500 annually.

Instead, you can use the £150,000 to pay as a deposit to buy another property with an expected 6% net total return. You can use the money to invest in the stock market with an 8% expected total return. You can do whatever you like with the money.

You cannot borrow from the bank such an amount at this rate to invest in the stock market. When taking out a mortgage, you specify reasons for the loan. But now that you have a mortgage, you do not need to prematurely terminate it. You are free to do what you want with the money.

Early repayment charges normally range between 1% and 5% of the early repayment’s value. Sometimes it is financially sound to pay the penalty to re-mortgage to a better deal. For example, saving more than 1% after considering all switching costs whilst the penalty is 1% can be beneficial.

When making an early repayment you can normally choose between shortening the mortgage’s term and keeping it. Shortening the term leaves monthly payments the same, but you pay less interest overall. Keeping the term the same reduces monthly payments. If you struggle with payments, opt for the latter.

Interest only or repayment

In a capital and interest mortgage (repayment mortgage), every monthly payment includes interest on the outstanding loan and capital repayment of some of the principal. Capital repayments reduce the outstanding mortgage every month. Over the term of the mortgage, typically up to 25 years, you repay it, ending up owning the property outright.

The advantage is reducing the interest portion as capital is paid over time. The disadvantage is monthly payments are larger than those of an interest only mortgage.

Interest only mortgage includes only interest in the monthly payments. The capital is repaid at the term’s end.

The advantages are deferring the repayment (time value of money), monthly payments are lower and inflation erodes the loan’s value. The disadvantage is you do not reduce capital and pay more interest over the mortgage’s life.

You must show the lender how you can repay an interest only mortgage at its term’s end. Examples of repayment plans include cash saved in savings accounts or ISAs; stocks and shares ISAs; pensions; investment bonds (a single premium life insurance policy where you invest a lump sum in with-profits or unit linked funds until surrender or death); endowment policies (life insurance contract designed to pay a lump sum after a specific term or on death where you pay regularly and your money is invested in with-profits or unit linked funds); and other assets.

Shopping around

Mortgage deals and rates are available online. You can get a mortgage promise (decision in principle or agreement in principle) even before finding a property.

After completing an online questionnaire, the lender conducts a credit search on you. You are informed whether and how much you can borrow. The final mortgage depends on finding a property, completing a valuation, finalising the mortgage with the lender and exchanging contracts.

When taking out a mortgage, the most important factors are the rate and features. The lender’s identity is less important. You are not buying a car where brand is significant. The lender should just show you the money. So, shop around.

Buy-to-let

If you buy a property with a mortgage, let it and its rental income less expenses cover the mortgage payments, by the end of the term of the mortgage, you can fully repay it. You end up owning the property. Owning a number of properties at retirement can be an income source. It can be a pension solution or complement savings.

You can make all the right actions when saving for retirement – saving in ISAs, maximising pension contributions and investing in financial markets. Yet, it may still be insufficient to deliver the income needed for your desired post-retirement standard of living. Buy-to-let properties can supplement your pension.

This materially differs from investing in capital markets. It requires a different skillset, time and energy. This is not for everyone. However, it can be a rewarding retirement solution.

The UK buy-to-let market has flourished because of a combination of attractive returns on residential properties, low borrowing costs and plummeting saving and annuity rates.

The advantages of buy-to-let are potentially lucrative returns, access to leverage via mortgages and a source of capital and income. It is not dependent on financial markets, fund managers or insurance companies. It is your business.

But buy-to-let does not come without risks. The main disadvantages include properties standing vacant (voids); capital intensity (down payments and renovations); demand for hard work, being a landlord and engaging agents, lawyers and tenants (dealing with people is difficult); leverage risk (properties can be repossessed); illiquidity; and poor property selection.

Building a portfolio of buy-to-let properties can take years and considerable efforts: saving for deposits, locating properties, arranging mortgages, renovating and letting. After retirement, you may be uninterested or unable to manage properties. Nudging tenants might call you frequently with problems. You can use a property management company, but it adds costs and it still requires oversight.

Before embarking on this adventure, carefully think whether it fits your lifestyle and personality.

Finding a property

The first step is locating a property to buy. Location is critical. Think what kind of tenants you want. Families normally prefer unfurnished houses, with a garden, parking space, at least three bedrooms and nearby schools. Being in a good school’s catchment area is valuable. Young professionals normally seek local amenities, such as restaurants and transportation. Students search for clean and comfortable flats close to campus.

Students may appreciate a tenancy agreement allowing them to sublet the property. This enables them to locate and share with flatmates.

Knowing the area helps with choosing the best location. That is why people tend to buy properties close to where they live. It also helps to reach them easily. The downside of doing so is lack of diversification, due to large exposure to one area via the main residence.

Think whether it would be easy to sell the property eventually. A ground floor flat could be a disadvantage due to security issues and lack of privacy. A top floor flat could be problematic due to stairs and high temperatures in summer. A flat high up in a building with a lift might mean an expensive service charge, which usually the landlord pays.

Flats in purpose built blocks usually come with hefty service charges. Conversions normally have no or low service charges, but the flats’ floor planning might be awkward.

Whether the ownership is freehold, leasehold or a share of freehold impacts the value. Ask your solicitor to explain to you the rights and obligations of each.

It is not only how the flat looks, but also how its building looks. You have control on refurbishing a flat, but you depend on neighbours to refurbish a building.

Is the property on a busy road with buses? Is it close to a noisy railway? Is it walking distance from train and bus stations? Does it have parking or is it easy to park near it? Is it over a noisy pub with smokers standing below its window? Is it next to a school with noisy children? Are the buildings near it residential, commercial or public? Ask yourself all these questions before buying.

Form good relationships with local estate agents. They are the main source for properties. Take your time to study the market’s dynamics. View many properties before deciding. Do not rush – this is a big decision.

Choose between a relatively cheap and shabby property, in an up-and-coming area, in need of possibly expensive and time-consuming renovations, and a more expensive property in good condition, that can be let out quickly. Having a good and trustworthy builder can tilt the balance. Property developers’ rough calculation is that a refurbished property’s final value should be at least purchase price, plus work’s cost plus 20%.

Haggle for price. If you are not reliant on selling a property to buy another, you are chain free. This can be an advantage when negotiating a price. Ideally, being a cash buyer who does not need a mortgage could be a bigger advantage.

Buy a property in which you would live yourself. You can buy a property with the potential of moving into it after retirement if you downsize your house.

Consider buying properties to gift to your children at a later stage to help them getting onto the property ladder, increase the chances they will live near you after you retire and mitigate IHT.

Calculate price per square foot or metre. This allows you to compare property prices across different locations and types. Ensure that the property’s floor plan makes sense – measurements might be inaccurate.

Down payment

Either save cash for a deposit over time or use the tax-free lump sum from your pension when retiring. It may be sufficient to buy a property outright without a mortgage.

Contemplate re-mortgaging your house to borrow a deposit, whether it is mortgage-free or by increasing an existing mortgage. The mortgage rate on your house will be lower than that on a personal loan. The quality of collateral (your house) makes it less risky for lenders.

Balance between the time it takes to save a bigger deposit (lowering LTV) and leverage risk of high LTV. Buying a property as early as possible can be an advantage if its value appreciates. This is the same principle of starting to save early. However, buying early may mean lacking time to save enough to reduce LTV, leading to higher borrowing costs. Trade-offs are everywhere.

Mortgage

Buy-to-let and residential (owner occupier) mortgages are different. Lenders look at prospective rental income to more than cover the mortgage payments. Most lenders demand monthly rental income of 125% of monthly mortgage payments. The deposit should be between 25% and 40% of the property’s value.

Buy-to-let mortgage rates tend to be higher than those of residential mortgages, reflecting the borrower’s higher default risk. First, you are likely to save your home before buy-to-let property in case of inability to pay the mortgage. For example, due to rising interest rates, loss of a job or excessive indebting. Second, there are risks of bad tenants and difficulties in letting properties.

Over recent years, buy-to-let rates have fallen in line with residential rates. But depending on LTV, buy-to-let rates can be 1% to 2% higher than equivalent residential mortgages. Shop around for a suitable deal, fitting your needs.

Having an existing mortgage on your home may affect your borrowing capacity. If you do not have a mortgage on your home, or if it is small, consider using your home to take a residential mortgage for a buy-to-let instead of a buy-to-let mortgage. This is called a homeowner loan and it is a way to release some equity from your house. The rate may be better. However, you are risking your home if you cannot repay your mortgage.

Use a broker to find a mortgage or approach lenders directly. Brokers search the whole market, whilst lenders offer only their products. A broker’s advice costs money (£400 to £500). Some lenders offer buy-to-let mortgages only via brokers.

The internet offers plenty of information on mortgages. It is easy to compare rates and lending terms.

Mortgage comparison websites (or commercial websites comparing any other financial products) can add costs to mortgages to cover their commission. They might exclude some mortgage providers. Conduct your own comparison by visiting websites of major mortgage providers, comparing deals. It takes time, but it can save money.

Interest-only mortgage

Commonly, borrowers take a repayment mortgage when buying a home and interest only when buying-to-let. Interest only mortgages have tax benefits, as interest is tax deductible on buy-to-let (landlords’ mortgage interest relief).

This might change, however, with changes phasing in between 2017 and 2020. Landlords might no longer be able to deduct the cost of their mortgage interest from rental income. The government may allow a tax credit equivalent to basic rate tax (20%) on interest, reducing profits from buy-to-let for some landlords.

Another advantage of interest only is lower monthly payments. For example, on a £150,000 mortgage at a 3% rate and 25-year term you pay £718 per month with repayment and £375 per month with interest only.¹¹

You can use the extra cash to cover maintenance costs. After 25 years when it is time to repay the principal, the potential appreciation in the property’s value (although you do not sell it) and inflation should help with repayment.

After 25 years, assuming 2% average annual inflation rate, a £150,000 mortgage is worth £91,430 in today’s values.¹² That is about 40% less.

Number crunching

Rents are seasonal. In August, for instance, you may get a higher rent due to demand from overseas relocations and students looking for residence ahead of the start of the academic year. In winter rents might be lower. When entering a tenancy agreement, you set the rent for the agreement’s term.

Similar to bond yields, property’s valuation metric is rental yield – estimated annual income expressed as a percentage of property price. For example, you are a cash buyer buying a property for £200,000. The rent is £1,200 per month or £14,400 per year.¹³ Gross rental yield is 7.2%.¹⁴

Compare the rental yield with other investments, such as cash deposits and gilts, for an objective cross-investment valuation. In particular, 10-year gilt yield should be the benchmark for properties.

For example, if rental yield is 7.2% and 10-year gilt yield is 2%, property appears better valued.

However, account for costs, including mortgage payments, maintenance costs, insurance, ground rent, service charges, estate agent fees (plus VAT), as well as estimated vacancy periods when the property does not pay rent.

Say you need a mortgage for the £200,000 property. You put a 25% deposit (£50,000), taking a £150,000 mortgage. At a 3% fixed rate on interest only you pay £375 per month (£4,500 per year). Maintenance costs and insurance are about 10% of rent (£1,440 per year). Your net rental income is £8,460, giving a 4.2% rental yield.

Add estate agent fees at another 10% of rent (£1,440 per year), and rental yield drops to 3.5%.^15,16 Instead, hiring a management company, which tenants call with problems, comes with a fee of about 15% of rent (£2,160 per year). Being hands-on and dealing with the property can save fees. However, be prepared to give up some spare time. Hiring a management company drops the rental yield to 3.2%.¹⁷

Bargain with estate agents on their fee. There are many agencies, creating competition. If you purchase your property through an agency, you may get a discount on the fee for letting it. Always haggle – everything is negotiable in business.

This still looks favourable compared to 2% yield of 10-year gilts. However, consider the risks of the property standing vacant (assume two-month vacancy per year), tenants missing payments, major works needed at the property and property’s illiquidity.¹⁸ Gilts are a relatively safe investment, whilst buy-to-let has risks and it requires extensive efforts. And this is yet before taxes.

Taxes

Stamp Duty Land Tax (SDLT) is due when buying a property, whether it is residential or buy-to-let. Calculate SDLT using the online calculator at www.tax.service.gov.uk/calculate-stamp-duty-land-tax. From April 2016 a 3% extra stamp duty on second homes and buy-to-let applies.¹⁹

Income tax is due on rental profits. Rates are the same as those on income and interest on savings. Deduct certain costs, called allowable expenses, from gross rent to calculate net rental profits.

Costs include property’s repair, letting agent fees, landlord insurance, mortgage interest payments, council tax and travel expenses to and from the property. Capital expenditures, such as purchase price and renovations beyond repairs of wear and tear, are not allowable expenses. Losses on rental income can be carried forward to set against future profits.

Until April 2016 landlords benefited from a 10% wear and tear allowance, even if they did not incur actual expenditures. This was scrapped and replaced in April 2016 with a relief enabling landlords to deduct costs they actually pay.²⁰

Deductible interest does not need to be on a buy-to-let mortgage. A mortgage on your home can qualify. You must show which interest payments were for the buy-to-let.

CGT applies when selling a buy-to-let (an additional 8% surcharge applies to residential property, so the rates are 18% and 28%). For CGT purposes, deduct some expenses associated with buying and managing the property. These include SDLT, fees to solicitors, estate agent and surveyors.²¹

Letting the property

Properties in the UK typically are let through estate agents. However, new avenues, such as Airbnb, offer new flexible ways for short-term letting.²² Short-term letting may be profitable and you cut out the middleman.

Holding company

Consider incorporating a company to own buy-to-let properties. It can reduce tax and make it easier to pass ownership to children.

When you own buy-to-let properties, rental profits are taxed at your marginal tax rate. Capital gains are taxed at 18% or 28%. When a company owns a property, rental profits and capital gains are taxed at the Corporation Tax rate of 20% (corporation tax will decrease from 20% to 17% in 2020).

When taking money out of a company, you pay income tax (if drawing a salary) or dividend tax in addition to the 20% Corporation Tax already paid.²³ Keeping profits in a company enables you to invest them in new properties at relatively benign tax rates. Growing a property portfolio may be more tax-efficient in a company.

Transferring existing properties into a company might be a disposal for CGT purposes, incurring a potential SDLT.²⁴ This is likely to be tax inefficient.

Gifting personally held buy-to-let properties to children incurs CGT on the basis of market value. The gift may be a potentially exempt transfer for IHT purposes. That is, there is no IHT on the gift if you survive for seven years.

If you incorporate a company to buy rental properties, you could make your children shareholders. They need to pay tax on dividends, capital distributions or sale of shares.²⁵

Consult your accountant or solicitor before establishing a company.

Summary

• Residential property is part of everyone’s financial planning.
• Leverage property by investing through mortgage financing.
• Accumulating a portfolio of buy-to-let properties could be a retirement solution or complement your pension.
• Gifting properties to your children can help them financially, mitigate IHT and increase chances of them living near you after retirement. You can use a buy-to-let property as your home after retirement if you plan to downsize your existing house.
• Consider incorporating a company to hold buy-to-let properties to mitigate taxes.

Notes

¹ The Telegraph offers a free online buy or rent calculator at www.telegraph.co.uk. It calculates after how many years you can breakeven by buying.

² No CGT is levied when selling your main home if you have one home and you have lived in it for all the time you have owned it; you have not let part of it; you have not used part of it for business only; the grounds are less than 5,000 square metres; and you did not buy it just to make a gain. Check www.gov.uk for details on CGT on your home and private residence relief.

³ Price appreciation: £16,000 = £200,000 × 8%; annual interest payment: £4,500 = £150,000 × 3%.

⁴ 23% = £11,500 ÷ £50,000.

⁵ Check www.nationwide.co.uk for a guide on mortgages. Many lenders offer free guidance on mortgages online.

⁶ First-time buyers can get up to £3,000 from the government to help buy a property through a Help to Buy ISA. You will need to save £200 each month and the government adds 25% on top. If you have a Help to Buy ISA you can transfer it into the new Lifetime ISA that will be introduced in 2017 or continue saving in both. However, you will only be able to use the government bonus from one to buy a house. London Help to Buy scheme helps Londoners to buy a property with just a 5% deposit and a mortgage as low as 55%. Check www.gov.uk and www.helptobuy.gov.uk for Help to Buy ISA and London Help to Buy.

⁷ Costs include stamp duty, mortgage arrangement fee, valuation fee, legal fees (including property searches), surveys, removal costs, home repairs, furniture and extras (light bulbs, door mats and so on).

⁸ Similar to a credit rating of a company, a credit score is a numeric expression of an individual’s creditworthiness. It is used by lenders to assess the likelihood that the individual will repay debts. You can get a free credit report and score from Experian at www.experian.co.uk.

⁹ 75% = £150,000 ÷ £200,000.

¹⁰ The website of BBC Homes at www.bbc.co.uk/homes offers a mortgage calculator with flexibility to input the mortgage repayment period and interest rate to calculate the monthly payments.

¹¹ Ibid.

¹² £91,430 = £150,000 ÷ (1 + 2%)²⁵.

¹³ Rent per month = rent per week × 52 ÷ 12.

¹⁴ 7.2% = 12 × £1,200 ÷ £200,000.

¹⁵ To calculate estate agent fees multiply the weekly rent by 52 and take 10% (or the estate agent fee) of the sum.

¹⁶ 3.5% = (12 × £1,200 − 12 × £375 − 10% × £14,400 − 10% × £14,400) ÷ £200,000.

¹⁷ 3.2% = (12 × £1,200 − 12 × £375 − 10% × £14,400 − 15% × £14,400) ÷ £200,000.

¹⁸ You can take an insurance against your tenant failing to pay rent (rent guarantee insurance).

¹⁹ Check www.gov.uk for SDLT rates and a free online calculator. SDLT no longer applies in Scotland and instead you pay Land and Buildings Transaction Tax when buying property.

²⁰ Check www.gov.uk for details on taxation of buy-to-let and property in general.

²¹ If buy-to-let was used at any point as your single or main residence during the last 18 months of ownership, it can qualify for a tax break known as private residence relief. This makes it free of CGT over this time period. From April 2019 the window for paying CGT on property will be cut from 10–22 months to 30 days after the transaction.

²² Check legislation banning short-term letting. For example, the Greater London Council Act 1973 bans letting out properties for less than three months, unless homeowners have a planning permission.

²³ When closing a company you could carry out members’ voluntary liquidation and pay CGT on any capital left. But 20% Corporation Tax on gains must be paid first.

²⁴ When a company buys a property worth over £500,000, the stamp duty is 15%, unless the property will be let out commercially to third parties and then the standard SDLT applies.

²⁵ If any children under the age of 18 received income from the company, the parents would be liable for the tax due.