- August 5, 2022
- Posted by: Rob
- Category: Pension
Rental Property yields can look attractive but can soon become poor once taxes and fees are considered
Thursday 28 July 2022 Author: Owen Foulkes
The last 14 years have seen a prolonged period of historically low interest rates and a constant upward trend in house values and rental costs. This has led to a boom in buy to let property purchases, with 2.7million people now letting out property in the UK.
Clearly the property market has been a good place to have money invested, with capital appreciation and every rising rental income bringing in bumper profits for landlords. However, recent changes to the tax relief available on mortgages and ever-increasing property process means those looking to enter the buy to let market may be better off looking elsewhere.
Higher Fees and Taxes
Cash savings have been a guaranteed way to lose money to the power of inflation for many years now, and in this environment a buy to let property yielding 6% sounds like a much more attractive option, particularly when you stand to benefit from house price growth too. But the return might not look quite as good once fees and taxes are factored into the equation. When buying a property, there are legal fees, survey fees and stamp duty to consider. Buy to let investors now face a 3% stamp duty surcharge too, which makes the cost of buying a property even steeper.
As well as the fees associated with purchase, there are also ongoing costs associated with running the property, which will reduce the gross yield to something less eye-catching hitting your bank account. You will need to pay for maintenance of the property, landlord insurance and letting fees, usually in the region of 15% if you do not intend to manage the tenancies yourself. You should also brace yourself for void periods when the house is vacant, as this will happen from time to time.
Then there is the issue of tax. Depending on your tax bracket, you’ll pay tax of 20%, 40% or 45% on the income generated by the property. If your income is just over £100,000, you face marginal income tax rates of up to 60%, because your personal tax-free allowance is reduced by £1 for each £2 of income above £100,000, until it is removed entirely.
You can still claim tax relief on the mortgage interest you pay, but this is now limited to 20%, rather than your marginal rate of up to 45%. When you come to sell the property, you will also face capital gains tax of 18% or 28% on any profits above the capital gains tax free allowance (currently £12,300), depending on whether you’re a basic rate or higher rate taxpayer.
On top of the costs, the tax you pay also serves to chip away at the returns that attracted you to the property purchase in the first place. That is particularly when you consider that other assets like shares or funds can be held in an ISA to protect them from tax.
The added bonus of investing in property is that you can fund a substantial proportion of it with money from a bank or building society. Doing this via a buy to let mortgage can boost your returns when the property market is on a roll. However, if property prices fall you can be left in the awkward position of having negative equity, which can hinder your chances of mortgaging (increasing costs) and mean that you may have to hold onto your asset much longer than originally planned.
You also must ensure that your rental income is enough to cover your mortgage payments, which has been relatively easy in the low interest rate environment over the last decade or so. However, as your mortgage deal ends you still face the risk of remortgaging at significantly higher rates, which may leave you in the unenviable position of having to fund the mortgage out of your other income.
A Tricky Retirement
Many people with buy to let properties consider them to be their retirement plan, but the points raised above suggest that this may not provide people with a secure retirement in the future.
However, there is a tax efficient alternative that everyone should consider. Any UK based individual can pay money into a pension, receive tax relief at their highest marginal rate, benefit from long-term, tax-free capital growth and then have the ability to draw a tax efficient income in retirement. This can also be done at low cost and your pension can be managed by a Financial Adviser, meaning all you have to do is sit back and enjoy the benefits.
As ever, it is prudent not to have your eggs all in one basket either, so if you buy a rental property, it is probably best alongside a pension portfolio to provide you with a degree of diversification and allow you to benefit from the tax advantages that pensions can offer.