Property Tax Planning Guide

Year-End Tax Planning for Property Investors

A FEW years ago most property investors were enjoying impressive capital gains. Those have now dried up in most parts of the country.

The good news is that many landlords are now enjoying healthy rental profits instead, thanks to strong demand for rented accommodation and relatively low interest rates on buy-to-let mortgages.

The bad news is that rental profits are taxed much more heavily than capital gains. Rental profits are added to your other income and typically taxed at 20%, 40% or 50%.

Looked at purely from a tax-saving perspective, income from property is a lot less attractive than income from other investments such as shares with high dividend yields or bonds. Dividends and interest income are completely tax free if you put your money in an ISA or pension. Rental income from residential property generally cannot be sheltered from the taxman.

Example
Samantha is a higher-rate taxpayer and earns rental profits of £10,000 during the 2011/12 tax year. Her total tax bill is £4,000 (£10,000 x 40%).

Miriam is a higher-rate taxpayer and earns dividends of £10,000 from investments held inside an ISA during the 2011/12 tax year. Her dividend income is completely tax free.

Although Miriam enjoys £4,000 more income than Samantha, possibly every year, many property investors would not countenance investing in anything else. “Nothing beats bricks and mortar,” goes the popular mantra.

However, despite wild up and down swings in financial markets, there are many companies that have increased their dividends every single year for the last 25 years – the so-called Dividend Aristocrats. Surely tax-free income from a diversified portfolio of shares in these companies is at least as appealing as fully taxed rental income from a portfolio of buy-to-let flats? Maybe something worth remembering the next time you consider buying an investment property for rental income purposes.

If you already own rental property, a more important question is: What property tax planning can be done to lower the taxable rental profits, in particular before the tax year ends on 5th April?
 
The answer depends on what you intend to do with your rental profits. Rental profits can be put to use in a number of different ways and some are more tax efficient than others:

Option #1 Spend the Money!
Many property investors rely on their rental profits to supplement their other income and pay the household bills.

Option #2 Build an Emergency Cash Reserve
Unlike most other investments, rental properties can make big demands on your wallet from time to time. I know this because I’ve just forked out £2,500 for a new boiler in one of my own properties! An emergency cash reserve will protect against unforeseen expenses or properties lying empty.

Option #3 Reduce Mortgages
Worth considering if you think your properties may fall in value or mortgage interest rates will rise. Consider reducing any mortgage on your own home first, however. This interest is generally not tax deductible, so it can be more expensive than interest on a buy-to-let mortgage.

Option #4 Buy More Rental Property
Alternatively you may wish to save up your rental profits to buy new properties. Samantha may have to wait up to five years to save up enough after-tax rental profit to afford a £30,000 deposit on a new property costing £150,000 (£6,000 x 5 years = £30,000). Nevertheless it remains an option.

If you use your rental profits for any of the above purposes, there is probably very little you can do to reduce your income tax bill. However, there are two other strategies that will either reduce or completely eliminate it:

Option #5 Upgrade Properties
If you spend money on your existing properties, the expense is normally treated as either a repair or an improvement. Repairs are immediately tax deductible and will save you up to 40% income tax if you are a higher-rate taxpayer.

Obvious examples are things that require urgent attention: broken windows, faulty boilers, etc. This type of repair is normally dealt with by the landlord immediately so discretionary year-end tax planning doesn’t come into the picture.

Improvements are not so good because tax relief is only provided when the property is sold and will only save you up to 28% capital gains tax. Improvements are generally new features that were not present in the property before and therefore increase its value: extensions, attic conversions, etc.

Between these two extremes is a hybrid type of repair spending that will give you full income tax relief at 40% or more AND may increase the value of your property. This type of spending should be the focus of your year-end tax planning.

Examples include: New kitchens, new bathrooms, double glazing, re-wiring and most decorating costs. Many property investors think of these items as improvements but they are in fact fully tax deductible repairs… providing you follow the rules. To be treated as repairs it is important that you replace old items with new items and do not add something new that was not present before.

For example, replacing a tatty old kitchen is a tax deductible repair. If you add extra kitchen units or sockets, these additional items will be improvements. Replacing a pea-green bathroom is a tax deductible repair. Installing a shower or downstairs toilet, where there wasn’t one before, is an improvement.

When replacing old items it is also important that you do not substantially upgrade the quality – that would be an improvement. However, it IS acceptable to install items that are of superior quality when they are simply the nearest modern equivalent, for example, replacing old single glazing with double glazing.

Option #4 Make Pension Contributions
If Samantha doesn’t want to spend any money on repairs one thing she can do to completely offset her income tax bill is make an £8,000 pension contribution. The taxman will add £2,000 of basic-rate tax relief directly to her pension pot resulting in a gross pension contribution of £10,000. She will also enjoy higher-rate tax relief of £2,000 when she submits her tax return (£10,000 x 20%).

All in all she will receive £4,000 tax relief, completely offsetting the income tax payable on her rental income. Over many years this simple strategy could leave Samantha tens of thousands of pounds better off.

Pension Contributions for Landlords
Before making pension contributions to offset the income tax payable on your rental income you should remember the following:

• Do you have earnings? Everyone under 75 can contribute up to £3,600 per year to a pension. If you want to contribute more than this you must have ‘earnings’. Salaries and business profits are earnings; rental profits generally are not.  If you want to make big pension contributions to reduce the income tax on your rental income, you must have earnings from other sources. 

• How big are your rental profits? To completely offset the income tax payable on your rental profits you may wish to calculate your rental profits before 5th April 2012. Leave yourself enough time to do this.

• Are you happy to invest in other assets? Pension savings cannot be used to invest in bricks and mortar, so residential property tax planning may not be the best way. Most people invest in shares and bonds, although commercial property is permissible, including commercial property funds.