Recent changes to buy-to-let (BTL) property tax rules have made it a lot more difficult to successfully make a profit from buying a house with a BTL mortgage. This buy-to-let guide outlines the tax changes and explains what to consider if you’re thinking of becoming a BTL investor and/or landlord.
What are the advantages of BTL investing?
Investing in property has proven to be a very profitable option over the last 20 years, and demand for rented property remains high because buying a house is still out of reach for many people.
Buy-to-let is a way of investing where you have some control over your investment – you can improve your return by redecorating, renovating and improving a property – unlike stock market investments that are dictated by market performance, or savings accounts where the interest rate can change.
One big advantage of BTL is the ability to earn in two different ways: rental income and property value increases.
The disadvantages of BTL investing
Think about the risks before using buy-to-let to invest in a property. The main question you need to answer is, could you afford mortgage repayments if:
- Interest rates go up
- You can’t find a tenant and thus have no rental income for a period of time
- The value of the property goes down
If interest rates rise, it means higher monthly repayments for you, but you may not simply be able to raise the rent to cover the difference.
Think about what you’re going to do at the end of a mortgage deal. If you’re currently on a fixed rate buy-to-let mortgage, what would happen if you have to switch to mortgage with a higher interest rate at the end of the deal?
What if your property is vacant between tenants? Factor into your budget it being empty for two months a year as insurance.
You must budget for repairs, new furniture and equipment, decorating and maintenance. Also, unexpected problems can and will occur; you need to have enough in the bank to cover a major repair, such as flooding or roof repairs.
Be prepared for rogue tenants who damage the property or leave owing money. They’re rare but they exist. This risk is reduced by the Tenancy Deposit Scheme and by taking out landlord insurance or rent guarantee insurance.
Buy-to-let tax changes
Two major changes were recently introduced to the buy-to-let market by the UK government. From April 2016 extra stamp duty charges were added to almost every BTL property purchase, and from April 2017 changes were made to how mortgage interest tax relief is applied.
Stamp duty for BTL properties
Anyone buying a BTL property now must pay an extra 3% of stamp duty above the usual rate – the same as if you were buying a second home.
For example, if you buy a residential property as your main home for £250,000, you would pay 2% stamp duty on the property’s value above £125,000. So you’d pay 2% of £125,000 – £2,500.
For a BTL property costing the same you’d pay 3% on the first £125,000, plus 5% on the remaining £125,000. In total you’d pay £10,000 in stamp duty.
Before the changes a BTL property would incur the same charges as a normal residential purchase, so in this example, the tax change adds £7,500 to a BTL property purchase. Read our stamp duty guide to see the various stamp duty tax bands for normal and second/BTL properties.
Mortgage interest tax relief
The second tax change is for mortgage interest tax relief. Most BTL properties are bought on an interest-only basis, with landlords relying on selling the property to repay the loan. Following a change in BTL income tax in April 2017, tax is now payable on rental income before mortgage interest is deducted. So, tax is now charged on turnover not profits.
The changes are being phased in over four years. So, in 2016/17, 100% of mortgage interest is deductible; in 2017/18 it’s 75%; 2018/19, 50%; 2019/20, 25%; and finally in 2020/2021, mortgage interest tax relief is limited to the basic rate of income tax, currently 20%. By restricting relief to 20%, the changes affect higher rate taxpayers more than basic rate taxpayers as they were entitled to relief at the higher rate, 40%.
Until 2016/17, landlords could deduct mortgage interest from rental income, before calculating tax. Now, only certain allowable costs can be deducted from rental income before tax. These costs include letting agent fees to find tenants and manage the property, advertising for a tenant, credit checks, building and contents insurance, council tax, utility bills, furniture, maintenance and repairs.
After deducting allowable costs, tax is then charged at 40% before mortgage interest relief is applied at 20% of the cost of mortgage interest.
So, under the old system if you had annual rental income of £12,000 and your mortgage cost £6,000 with allowable costs of £2,000, taxable income would be £4,000. Tax due at 40% would be £1,600, resulting in BTL profit of £2,400.
Under the new system, once it’s fully implemented in 2020/21, with rental income of £12,000 and allowable costs of £2,000, the taxable income is £10,000 – a tax bill of £4,000 at 40%. Mortgage interest tax relief is deducted at 20% of £6,000, so, £1,200 is taken off to leave tax due of £2,800. This means your profit is just £1,200 – half the amount under the old system.
What is the impact of the tax changes?
Mortgage interest amounts cannot now be included as an allowable deduction before tax is charged on the remainder. Now, mortgage interest tax relief is applied at a blanket rate of 20% on all mortgage interest payments on a BTL property. This reduces profits in almost all cases.
Find out more about tax changes at the Money Advice Service website.
How to get a BTL mortgage
Lending criteria on all mortgage lending has tightened following 2014’s mortgage market review. To be accepted for a buy-to-let mortgage you normally need a 20% deposit and to prove that rental income will be at least 125% of mortgage interest repayments. Normally, you need a minimum income, usually £25,000 for a BTL application, and to meet any other lender affordability criteria.
BTL mortgage interest rates
Rates are usually higher for buy-to-let than for residential mortgages, but all mortgage rates are still historically low. Due to the tax changes some landlords have left the BTL market, so lenders are now offering the lowest BTL rates seen since records began in 2012. The average BTL interest rate for someone with a 25% deposit is 2.27%.
Like all mortgages, the bigger the deposit, the smaller the loan-to-value (LTV) ratio and the better the deals available.
But interest rates could rise so you must be sure that your investment could cope with higher rates.
What is BTL yield?
When you’re negotiating a mortgage, the lender will want to know what your expected rental yield will be.
Rental yield is the annual rent received as a percentage of the property purchase price. So, for a property costing £240,000, an annual rent of £12,000 means a yield of 5%.
Ideally you should aim for a rental yield of around 8% so there’s cashflow to cover expenses, maintenance costs and problems.
Rental yield is a measurement of how much cash an asset, in this case a BTL property, generates each year as a percentage of the asset’s value. Gross yield is the return before expenses, and net yield is the return after costs and provides a truer picture of profit for a BTL investor or landlord.
What extra costs come with a BTL property?
Extra costs can include property damage, roof repairs, new furniture, fences and more. Many of these costs are allowable expenses, so are tax deductible.
The biggest hit to BTL rental income will likely be periods without a tenant. When a tenant leaves, it may take time to replace them and losing even one month of rental income can have a big impact on rental yield.
Where are the best places to invest in buy-to-let property?
University towns with a new intake of students every year or cities with cheap housing are often the best BTL locations with the strongest yields.
First, decide on the type of property you can afford. Your choice of property will attract different groups of tenants. If you can only afford a one-bedroom or studio flat, then you’ll likely rent to a student, single professional or a couple. Larger properties give more options including families. If you opt for families, consider what the local schools are like.
If you opt for students, consider university towns; many have purpose built flats designed for BTL investors to rent out to students.
The right location is one where people want to live which can be for all sorts of reasons. Match the type of property you can afford with who wants to live in that type of home in that location.
Target the right tenant
Once you understand what type of tenant wants to live in your property in that area, you know who to target with advertising.
If you’re targeting short-term tenants and expect them to move regularly you may not want them to redecorate – but if you’re looking for longer term tenants, allowing them to personalise the property will make it feel more like home and make it likely they’ll stay longer, which is what you want as a landlord.