•What is equity release?
•Tax-efficient equity release
•The disallowed interest trap
•The CGT trap
•The need for a balance sheet
I recently met a new client, who has a portfolio of about seven buy to let properties. As we sat together going through the schedule listing them by cost, rent yield, market value, and mortgage interest payable, I realised that this person had fallen (or been pushed by a previous adviser) into one of the classic traps that lie in wait for buy to let landlords. What made it even worse was that this new client had explained that they wanted to consult me specifically about selling up and retiring, and the trap they were in was going to make that very difficult to achieve.
A long time ago, when I first began to specialise in property tax, I attended a seminar given by one of the many ‘property investment advisors’ that were springing up at that time. A spy in the enemy camp, if you like!
The whole thing was very energetic, very upbeat, and very hard selling. One of the central themes of the presentation was offered as the great ‘secret’ of successful property investment – equity release.
The presenter explained that this meant increasing the amount of the loan secured on your rental properties as they grew in value (I did say this was a long time ago!), and using the cash raised for your own living expenses. He explained (with the air of one who imparts a powerful trade secret) that no tax was payable as a result of the equity release, so we would be getting ‘tax-free cash’ out of our letting business.
What the presenter said was true as far as it went, but he completely failed to mention the two serious problems that can arise as a result of too much equity release: disallowed interest, and potential bankruptcy on sale.
Let us first look at what does work:
Example 1 – Tax-efficient equity release
Joe inherits a cottage, ‘Dunliving’ from his grandfather, with a probate value of £200,000. He decides he will keep it and lets it out. He also needs some cash, for improvements to his home and for a new car, so he arranges a mortgage of £100,000 secured on Dunliving. He spends the money on the improvements and a really nice car. Because the amount borrowed against Dunliving is less than its market value when Joe first began to let it out, Joe can deduct the interest on the loan from the rental income. Some years later, he borrows a further £75,000 secured again on Dunliving, and uses it to pay off what remains of the mortgage on his home. The total borrowed, £175,000, is still less than the £200,000 market value when the property was first let, so the additional interest on the mortgage can still be deducted from the rent.
Joe has improved his house, bought a really good car, and paid off his home mortgage, and all the interest on the loans he used to do this is an allowable expense against the rent from Dunliving.
The basic rule
Interest on loans secured on a let property is an allowable expense against the letting income provided the amount borrowed is not greater than the market value of the property when it was first let; and it does not matter what the cash raised is used for. The reasons for this are explained in detail in paragraph BIM45700 of HM Revenue & Customs ‘Business Income Manual’, which can be found on their website (www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htm).
Trap – Disallowed interest
The disallowed interest trap can be illustrated by the following example.
Example 2 – Too much equity released
Joe’s sister Joan inherited grandpa’s other cottage, ‘Dunworking’, also valued at £200,000. Like Joe, she released equity from the property and used it for various private expenses, but as Dunworking is situated in a holiday resort its value has increased much faster than that of Dunliving. After ten years, it is worth £300,000, and Joan is able to release a total of £250,000 equity, which she uses to improve her home and buy attractive consumer goods.
What she does not realise is that because the loan is now greater than the original market value of the property when first let, 50/250 of the interest payable on the loan cannot be deducted from the rent as an expense.
Selling and tax
The other trap for those who release too much equity from their properties is capital gains tax (CGT). This will be payable on the gain arising when a buy to let property is sold, and at a rate of 28% (assuming the vendor has none of their basic rate tax band of £32,010 left – if they do, an equivalent part of the gain will be taxable at 18%).
At the risk of stating the obvious, if you sell a property you have to pay off the mortgage on it, and this can lead to serious problems:
Trap – Unfinanced CGT
Once again, this CGT trap can be illustrated by an example.
Example 3 – A sting in the tail
Joan has continued to release equity from Dunworking, which is now worth £400,000, with a loan of £350,000 secured on it – Joan now drives a Porsche, and her home is a designer’s dream. She decides, however, that she would like to sell up and retire abroad, so she puts Dunworking on the market. After some fierce competition among buyers, it sells for £410,000, leaving Joan with £40,000 after paying off the mortgage and paying the legal and estate agent’s fees of £20,000. This gives rise to a capital gain of £190,000 (proceeds after fees = £390,000, less original probate value £200,000). After allowing for her annual exempt amount of £10,900, CGT is payable at 28% on £179,100 – tax due of £50,148.
Joan has to sell the Porsche to find the £10,148 not covered by the remains of the sale proceeds – and the change from the sale proceeds of the car will help with the back taxes she has to pay, as the taxman has just discovered she has been over-claiming interest on her rental property for several years!
Growing the business
All the previous examples have dealt with the situation that can arise when the cash from equity release is treated as ‘tax-free cash’ and spent on things unconnected with the rental business. If instead the equity released is used to buy another rental property, or to finance repairs or improvements to let properties, then the interest on the loan will be an allowable expense, because the loan was for the purposes of the property business, not for the purpose of drawing money out for private expenditure. The problem with CGT on a sale of the property can still arise, however.
The releasing of equity from a let property by increasing the borrowing secured on it is not itself an occasion on which tax has to be paid, but as we have seen, it can easily lead to problems with both income tax (on the interest disallowed), and CGT (on the tax due from a sale).
Practical Tip :
In the real world – and in the portfolio of the unfortunate client I described at the start of this article – equity release is used for a mixture of personal and property business expenditure.
In order to keep track of this, if you are going to use equity release as part of your property business strategy, it is essential to prepare full accounts, with a balance sheet as well as a profit and loss account, in order to make sure that the total loans secured on the business properties are not greater than the total market value of the properties when first let. If you read paragraph BIM45700, you will understand exactly how this works, and why a balance sheet is necessary.