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Tax deductions are inefficient

Investments must stand on their own merits, regardless of financing model used. Factoring in tax deductions can distort the selection outcome.

Regulatory risks will always exist

Recently the UK government pulled the rug from underneath buy-to-let landlord’s collective feet. They decided that taxable income from buy-to-let properties should be calculated before, rather than after, financing costs were factored in.

Rug pulled from underneath feet

For many years income tax due on property income was calculated based on the landlord’s profit after operating and finance expenses. A generation of landlords had, in part, made their investment decisions based upon those rules.

Taxable Profit = Rental Income – Operating Expenses – Financing Costs
After the changes income tax due on the property income was calculated using the operating profit, before the cost of financing was applied.

Taxable Profit = Rental Income – Operating Expenses
Landlords are still able to claim a deduction of up to 20% of their financing costs, but that deduction applies to the new table profit figure, meaning it is up to 20% of a much higher taxable income figure. Rob Dix has produced a good write up of these changes.

This is a big deal for landlords holding properties in low yielding but high capital growth markets like London. The strategy for them has long been to purchase the best located property they could afford, minimise holding costs, and ride the capital growth rocket ship to the moon.

Capital growth rocket ship to the moon
Capital growth rocket ship to the moon

Paying tax on loss making investments? WTF!?!

Now many will be paying out tax on loss making properties, where any operating profit the property may earn is more than consumed by financing costs.

There is an argument to be made that the changes should only have applied to buy-to-let properties purchased after the date the new rules came into effect, so that potential investors could refine their investment selection criteria. Unfortunately that did not happen.

As a landlord owning property in London, at first I was a tad underwhelmed by the changes. I thought it unfair to retrospectively change the rules of the game.

I dusted off my trusty property evaluation spreadsheet and ran the numbers for my portfolio using the new rules. Based on chorus of wailing and chest beating emanating from the various ineffective landlord industry associations and lobby groups, I expected to feel like I had been screwed with my pants on.

However the results weren’t that bad. My portfolio would still be profitable. It remained self funding. It was still cashflow positive. That cashflow was reduced somewhat, due to the new tax calculation method.

Fundamentally I owned good quality, well located property, in an area of high tenant demand. My gearing levels were set conservatively enough to cope with void periods or unexpected maintenance costs, without needing to dip into my own wallet.

That got me thinking. How many of these landlords had made their investment decisions based upon the after tax picture, rather than concentrating on the fundamentals of the investment property itself?

So what?

A good investment must stand on its own merits, regardless of the financing model an investor may use to purchase it. Factoring income tax rates and particular tax deductions into the investment selection equation distorts the outcome, and is likely to result in suboptimal investment choices.

2 comments :

Chad Carson said...

Wow, this is eye-opening! I've often told people the same thing - don't depend upon tax benefits to buy your investments. It needs to stand on it's own two feet. But this is exactly the kind of changes revenue starved governments can and will make overtime. The relatively small number of "rich" landlords are an easier target that tax hikes on much larger constituencies, right? Makes political sense.

So thanks for sharing this with us as investors across the pond. It helps us judge our own future risks.

And I'm also going to check out more of your property articles. It's nice to read about your perspective in a different market and still having success.

Cheers!

Slow Dad said...

Thanks Chad. The rules of thumb definitely vary from place to place.

As I understand it in the US owner occupiers can even claim their mortgage interest as an income tax deduction in some circumstances! Combine that with the availability of (very) long term fixed rate mortgages, it creates a very favourable environment for property owners.

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