This article appeared in the York Press on Saturday, May 17, 2008.

Long term it’s not all doom and gloom for property market

Duncan Meredith Tax Consultant

There is much doom and gloom about the property market, and residential property in particular, at the moment.  The collapse of the ‘sub-prime’ mortgage market in the U.S. has had a knock-on effect.  Close to home, Northern Rock was a stark reminder of what can happen when the ‘bubble bursts’, and of course it is not the only UK bank affected.

In spite of this, it was refreshing recently to read a report from one of the banks themselves (Schroders), where there seemed still to be much cause for optimism.  For example, it was noted that, historically, private rented residential property has been high performing and relatively stable, with residential capital values increasing annually at an average rate of 9.5% (on the Government’s own figures) over the last ten years.

There is no doubt that the easy credit that has fuelled the double-digit growth in house prices will not be seen again soon.  Nevertheless, some of the local High Street bankers I see are upbeat about having funds to lend.

So, in spite of the credit crunch and fears of a house price crash, whilst prices might fall in the next few months, Schroders felt that, in the medium to long term, the supply and demand imbalance should mean that house prices and demand for rentals should not suffer.  Indeed, a loss of appetite for buying will tend to push up demand for rented properties.  The conclusion was that the emphasis would be on good management and selecting the right locations in which to invest.

So where does tax fit into all of this?

First, while funding issues and availability of credit are a real and practical concern, they do not have any direct relevance to tax (apart from claiming a deduction for interest paid).  I am often surprised by property owners who assume that any tax they will pay on a sale will be calculated by striking the profit net of any borrowings.  That is not so!

The new capital gains tax (CGT) rules mean that only direct purchase (and improvement) costs can be set against proceeds (net of selling costs) before calculating the amount of the gain.  This is now taxed at a straight 18%.  The only exceptions to this for residential property are if Private Residence Relief (whole or partial exemption) or treatment as Furnished Holiday Lets (FHLs) (qualifying for Entrepreneurs’ Relief) are available.

In cash terms, the net proceeds from sale must be used to satisfy any borrowings on the property and to pay any CGT liability.  This is commonly the problem faced by property investors, who have geared up to increase their portfolios.  The loans secured against a particular property might be very high and there is not enough cash left from the sale to pay the tax after the loans are repaid.  Even worse, this tax has to be calculated without taking the loans into account!

Another problem that could occur at this time is a down turn in rental demand (perhaps by a tendency for people to house-share in the short-term, while the property and lending market settles).  For the owner of rental properties, this could mean that rental income does not cover the interest and other annual costs associated with the property, particularly if lenders are not passing on the reductions made by the Bank of England.

In this connection, it should be noted that interest is deductible if it is incurred ‘wholly and exclusively’ for the lettings business.  Which property it is secured on is irrelevant.  So, the loan may have been taken out on the family home or on another let property but, as long as it is used, broadly, to acquire or improve a residential property that is to be let, the interest is deductible.

Nowadays, profits from a lettings business are calculated for tax in exactly the same way as if it were a trade.  All properties are pooled so that individual losses on a particular property tend to be offset against other rents, in the current year.  If there is an overall loss on the lettings as a whole, this can only be carried forward to be set against future rents.  The exception to this is FHLs, where losses can be set against other income and gains of current and the prior year, so generally obtaining immediate relief.

You will have gathered that FHLs are taxed differently from other residential lets.  In many ways they receive more favourable treatment but a detailed examination of them is outside the scope of this article.

Rental accounts are drawn up to 5 April for tax.  Maximise deductions by ensuring that all expenses are claimed: advertising costs; management fees; legal fees for rent agreements etc.; interest on borrowings; repairs; insurance; water and sewerage and accountant’s fees.  There is also a deduction of 10% of rent, to cover wear and tear on furniture.

If selling, ensure you have captured all of the initial costs (including stamp duty/SDLT, search costs and legal fees).  Include expenditure on improvements (including any repairs that have not been allowable against rent).

So, in spite of the down turn, there remains optimism that most landlords should see it through.  In the meantime, ensure that you maximise your claims for relief, both on an annual basis against rental income and for CGT purposes if you are selling.

Garbutt & Elliott are Chartered Accountants and Tax Advisers with offices in Leeds (0113 2739600) and York (01904 464100).  Duncan can be contacted at the York office, or by email to dmeredith@garbutt-elliott.co.uk.