It is still difficult to remember that we have a new Chancellor, and that Gordon Brown is no longer in charge of our tax system. However, Alistair Darling clearly wants tomake hismark, and his pre-Budget report lastmonth was the start of this. He seemed to go out of his way to distance himself fromhis predecessor (and new boss), for example, by announcing thatmarried couples could now share their inheritance tax liability — something the Inland Revenue had spent the last 10 years under Brown trying to stop us doing.
Nowhere was this ‘new broom’ approach more obvious than capital gains tax (CGT). This had been one of Gordon Brown’s two big reforms when he took office 10 years ago; he made pension funds pay more tax (and what a disaster that was), but also completely changed the CGT system. Under his new ‘taper relief’, whenever we sell a capital asset a proportion of the gain could be tax free, depending on what it is and how long we’ve owned it for. This was Brown’s big set piece, showing that New Labour had changed and could be probusiness and pro-investment. Brown even claimed at the time that his tax reforms sent a clear signal: "my message to business is — this government is on your side."
Now Darling says that taper relief is to be abolished, for all sales after 5 April, 2008. Instead of being able to claim taper relief (and indexation allowance and other minor reliefs), there will be a new lower tax rate of 18%.
Small businesses bear the brunt
Unfortunately, that isn’t good news for everyone. In particular the owners of small businesses are set to lose out; under taper relief three quarters of their gain was free of tax. Although they probably had to pay 40% top rate tax on the remainder, paying 40% on just a quarter of your gain is equivalent to paying just 10% tax on the whole thing — just over half the 18% now proposed by Darling.
But for buy-to-let investors, Darling’s capital gains tax reforms have been heralded as good news. Under the old system, buy-to-lets didn’t qualify as ‘business assets’, so the taper relief that you could claim was much less, as shown below:
Taper relief on residential buy-to-let
| Effective tax rate for: | |||
| Years owned | Taper relief | Basic rate taxpayer | Higher rate taxpayer |
| 0 | NIL | 20% | 40% |
| 1 | NIL | 20% | 40% |
| 2 | NIL | 20% | 40% |
| 3 | 5% | 19% | 38% |
| 4 | 10% | 18% | 36% |
| 5 | 15% | 17% | 34% |
| 6 | 20% | 16% | 32% |
| 7 | 25% | 15% | 30% |
| 8 | 30% | 14% | 28% |
| 9 | 35% | 13% | 26% |
| 10+ | 40% | 12% | 24% |
Compare that to the new system, with a single rate of 18% for all capital gains, and almost all buy-to-let investors are going to be paying less tax; in some cases, substantially less. The least you would pay under the taper relief system was 24% as a higher rate taxpayer (and even if you don’t pay higher rate tax normally, a decent capital gain on your buy-to-let should take you well into that band). A typical buy-to-let investor who has owned a flat for four or five years will find his tax bill will be halved if he sells after 5 April, 2008.
That’s a big tax reduction, but is it really good news?
An April stampede out of the market?
The problem is the effect this is going to have on all your fellow buy-to-let investors, and the danger that it could create an April stampede out of the market.
Thanks to the recent housing market bubble, most buy-to-let investors are sitting on large capital gains but getting tiny rental yields. The price of houses, and flats in particular, has risen strongly, but rents have not kept pace (and are unlikely to do so; people will pay an inflated price to buy a house if they think it is a good investment, but they have to pay rent out of their income).
With the market expected to flatten out — if not worse — the temptation for many investors is to sell and take the profit, but people are put off that by the thought of a huge capital gains tax bill. If that tax bill is halved from 6 April, a lot of buy-to-let owners could see that as a good time to sell, flooding the market just when it is looking fragile.
Let’s look at an example. Say Mr Brown (no, not that one) bought a typical London flat three years ago in a reasonable area but not right in the prime centre. He paid £225,000 with an 80% interest-only mortgage. He is now letting it out for a monthly rental of £1,350, but the initial discount on his mortgage is running out so his interest rate is about to go up to 7.59%. That leaves him with a profit of £212 per month, or just £1,526 per year after tax — and that’s before deducting any management or maintenance costs. Even if he has time to do the management and maintenance himself, he won’t be getting very much each month for his effort.
That flat is probably now worth £330,000, so Mr Brown’s investment has been a good one despite the feeble monthly cash returns. This could be a good time to sell, but if he does then he’ll be hit for 40% capital gains tax:
| £ | |
| Sale proceeds | 330,000 |
| Less cost | (225,000) |
| Gain | 105,000 |
| Less taper relief (5%) | (5,250) |
| 99,750 | |
| Less annual exemption | (9.200) |
| Taxable gain | 90,550 |
Assuming he’s a higher rate taxpayer, Mr Brown will have to pay tax at 40% on £90,550; that’s a tax bill of £36,220. Even if he isn’t a higher rate taxpayer normally, a capital gain of that size will take him well into the 40% bracket. The problem is that if he sells his buy-to-let, that sort of tax bill doesn’t leave him with very much to reinvest elsewhere.
However if he waits until after 5 April, 2008 before selling, his capital gains tax will come down to just 18%, leaving him with over £132,000:
| £ | |
| Sale proceeds | 330,000 |
| Less outstanding mortgage | (180,000) |
| Less Capital Gains Tax (18%) | (17,244) |
| Net cash remaining to invest | 132,756 |
Now, is Mr Brown’s buy-to-let still a good investment? Forget what he paid for it; that’s history; what you need to look at is the return he is getting from his investment, compared to what he could get elsewhere. This is why the capital gains tax matters; the less tax he has to pay on selling his buy-to-let, the more he could have to invest elsewhere and therefore the more income he could get from an alternative investment.
Mr Brown’s real investment in that property is £132,756, the net cash he could get on selling it. His profit on that (assuming he doesn’t have to pay an agent, or any maintenance costs) is just £1,526 per year. That’s an annual yield of barely 0.1%.
The real situation is even worse; factor in a 12% management fee, £900 per year maintenance and five weeks per year void, and he is looking at an annual loss of 1.3%. Even with a fairly optimistic house price increase for the next couple of years (say 6% per year, less 18% tax) that leaves him with a net yield of just 2.3% p.a. (3.7% with no management or maintenance fees).
Compare that to other investments and the return is pathetic. A return of 2.3% to 3.7% would be poor even for a low-risk investment — the Abbey is offering 4.1% after tax on its guaranteed savings bond! But buy-to-let is hardly risk-free at the moment, so perhaps for a more accurate comparison you should look at unit trusts. Some of those have performed very well; gold funds are up 50% in the last 12 months, India or Eastern Europe about the same, and plenty of China funds are returning over 100% on the year.
Compared with those, Mr Brown’s buy-to-let is now grossly underperforming.
Remember also that you don’t have to do much work to invest in a unit trust, and you don’t have a £180,000 mortgage hanging over your finances.
The next house price crash
If you have a buy-to-let this doesn’t mean that you should necessarily sell, but lots of other investors will be doing the same sums, and many of them will conclude that buy-to-let just isn’t worth the hassle for the next few years.
What would that do to the housing market? There are about 800,000 houses owned on buy-to-let mortgages. Normally about 450,000 houses come on to the market each quarter, so even if just 20% of buyto- lets are put up for sale next April that would mean an extra 160,000 houses, 35% more than normal. That would certainly flood the market, and with confidence low anyway, it could easily cause a slump.
Anyone can be caught out by unexpected changes in the market, but there’s no excuse this time; we have been given six months notice of the tax changes that could cause the next house price crash.
