Buy To Let Tax Traps: What Doctors Need To Know 

The Government has increased taxation of buy to let at all three stages of the life of the investment – purchase, ongoing letting and disposal.  Doctors who have or are considering a second home as a rental property need to be aware of how a buy to let investment will be taxed to avoid falling into ‘tax traps’.

1.       Stamp duty on purchase

Doctors who already own a home must watch out for the stamp duty land tax charge on the purchase of additional residential property.  The rates for second (or further) homes are 3% higher than for the purchase of a main residence.  This expense needs to be borne in mind when considering a buy to let property as it will increase the cost of the purchase and affect your budget.  For example the stamp duty on a property worth £300,000 would be £5,000 if a main residence but £14,000 for a buy to let investment.

The stamp duty land tax rates are shown in the table below. 

Property value

Main residence

Second home

Up to £125,000

0%

3%

The next £125,000 (the portion from £125,001 to £250,000)

2%

5%

The next £675,000 (the portion from £250,001 to £925,000)

5%

8%

The next £575,000 (the portion from £925,001 to £1.5m)

10%

13%

The remaining amount (£1.5m+)

12%

15%

Example calculation for a £300,000 property: if main residence (£125,000*0%) + (£125,000*2%) + (£50,000*5%) = £5,000; if second home (£125,000*3%) + (£125,000*5%) + (£50,000*8%) = £14,000.

2.       Reduction in income tax relief

Profits on rental property (i.e. rental income minus costs) are subject to income tax.  Historically, mortgage interest could be counted as a cost, reducing the taxable profit.  As mortgage interest was deducted from the profits before tax it was paid out of untaxed income, meaning doctors were obtaining income tax relief on the mortgage interest at their top rate of tax (basic, higher or additional rate). 

This is now being phased out at the higher and additional rates and from 2020/21 onwards tax relief on mortgage interest will only be available at the basic rate.  The basic rate relief will also be given as a credit, rather than reducing the taxable profits.  This will affect all landlords but will have a significant impact on;

  • landlords who have a mortgage, and
  • who are higher/additional rate taxpayers.

The first result of these changes is that taxable profits on buy to let investments will go up.  The consequences of this increase in taxable income to beware of are:

  • Doctors who are close to the basic/higher rate or higher/additional rate tax thresholds could be pushed into the next tax bracket
  • Doctors with children will have their child benefit reduced by means of the child benefit tax charge if their income is increased over £50,000
  • Higher earners will start to be affected by a reduced pension Annual Allowance as their income goes over £150,000.  This is of particular relevance to doctors who are members of the NHS Pension Scheme, where it is plausible for continuing membership to result in exceeding the Annual Allowance

The second result of the tax changes is that tax on the profits will go up for landlords who have a mortgage and are higher/additional rate taxpayers.  Doctors in this category will see a reduction in their net (after tax) income. 

The impact of these changes is best shown in an example.  A higher rate tax-paying doctor receiving rental income of £10,000 a year and paying £6,000 mortgage interest a year will see their taxable profit increase from £4,000 in 2016/17 to £10,000 in 2020/21.  Their tax bill will go up from £1,600 in 2016/17 to £2,800 in 2020/21.  Their net profits will reduce from £2,400 in 2016/17 to £1,200 in 2020/21.  How this works is shown in the table below:

 

2016/17

2017/18

2018/19

2019/20

2020/21

Rental income

£10,000

£10,000

£10,000

£10,000

£10,000

Mortgage interest paid

£6,000

£6,000

£6,000

£6,000

£6,000

Interest deductible

£6,000 (100%)

£4,500 (75%)

£3,000 (50%)

£1,500 (25%)

£0

(0%)

Taxable profit

£4,000

£5,500

£7,000

£8,500

£10,000

Tax at 40%

£1,600

£2,200

£2,800

£3,400

£4,000

Less basic rate credit at 20%

-

£300

£600

£900

£1,200

Total tax due

£1,600

£1,900

£2,200

£2,500

£2,800

Net receipt after tax and interest paid

£2,400

£2,100

£1,800

£1,500

£1,200

 

Higher/additional rate taxpaying buy-to-let investors will need to consider their position and take action accordingly.  A possible solution could, for example, include repaying the mortgage if funds are available.  Some doctors may consider moving their property investment into a limited company to sidestep these tax changes although advice must be sought as alternative taxes and costs would apply.

Potential solutions to the child benefit and Annual Allowance tax traps mentioned above could be to transfer the property and rental income to a lower earning spouse/civil partner.  Where the child benefit tax charge is an issue but Annual Allowance is not, another option is making a personal pension contribution to reduce income for the purposes of this calculation.

3.       Inheritance Tax liability

One tax consequence of buy to let investment that doctors should not overlook is the potential Inheritance Tax (IHT) liability.  Property is a long term investment and one of the aims is to benefit from increases in property prices over time as well as generating rental income in the meantime.  This type of investment may well be open-ended, with no fixed ‘sell’ date in mind, with many doctors hoping the income will continue into their retirement and assuming their children could later inherit the property.  However, unlike the main residence which benefits from the new ‘residence nil rate band’ for IHT when passed to a direct descendant, there are no concessions for investment properties.  Any increase in value in the property will increase the value of the estate for IHT purposes, and hence the IHT liability where the estate exceeds the nil rate band (£325,000 for individuals, £650,000 joint).

Where IHT is an issue, there are financial planning options available including taking out insurance to cover the liability.  Gifting is another strategy, although care must be taken if the decision is made to gift the property before death in order to avoid IHT as it takes seven years for a gift to be considered fully out of the estate for IHT purposes.  Again, insurance can be used to cover the IHT liability for these seven years if required.  It must also be a true gift – where the donor ceases to benefit in any way from the property – in order to avoid triggering ‘gift with reservation’ or ‘pre-owned assets tax’ charges.  Note that Capital Gains Tax applies to lifetime gifts – see below.

4.       Capital Gains Tax

Finally, remember that doctors who sell their second property or gift it in their lifetime rather than leaving it as an inheritance on death will pay Capital Gains Tax (CGT) on any gains.  While main residences can be sold CGT-free, second properties attract CGT at 18% for basic rate taxpayers and 28% for higher rate taxpayers on the increase in the property’s value (the difference between the cost of purchase and proceeds on sale).  In 2016 the rates of CGT reduced for other types of investment (e.g. shares and funds) but the Government kept CGT on second (or further) homes at the higher level.

 

Please note this article does not constitute personal financial advice.  For advice on your personal situation please contact Richard Higgs CFP FPFS on 0117 966 5699 or richard.higgs@wealthwestmedical.co.uk.  Please note tax rules are subject to change by the Government and the value of any tax benefits depends on individual circumstances.

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