Landlords beware: Taxation is coming
When Rishi Sunak stood up to speak in the House of Commons in March 2021 it was with a sense of anxiety in the wider populous.
Many pundits and onlookers were concerned there may be some steep and punishing changes to UK taxation to fill the hole in the books of the UK economy. This had been created by the furlough process and other government initiatives to support business following the outbreak of COVID-19.
While initially relieved there were no big uplifts in taxation, many creeping tax issues created by medium term freezes were created, as well as longer term planning challenges.
Although several allowances were impacted, the freeze on capital gains tax (CGT) and inheritance tax (IHT) are the ones that need to be focused on for landlords.
Why is it important? Frozen rates need to be considered against realistic rates of growth.
There are many different measures for the value residential property, adjusted for inflation and accounting or discounting certain areas. Where there is certainty is that the value has continued to increase. If we consider growth in house prices since May 2011 the national average increase is 5.2 per cent per annum (simple growth assumed).
As we know, not every area grows at the same rate at the same time. The northwest is growing at 15.2 per cent per annum compared to the east of England at 6.9 per cent per annum in the 12 months to May 2021, boosted by the Stamp Duty Land Tax (SDLT) holiday implemented in 2020.
Taking the average growth rate at 5.2 per cent, if a landlord has a rental property valued at £250,000 the annual gain would be £13,000. In one year an individual would have seen enough of an increase that, on disposal the gain would exceed their £12,300 current capital gains allowance and face a capital gains charge. This also does not take into account gains that have not been crystallised already.
Many landlords are not interested in selling their properties and realising these gains. I have heard a number of clients saying that their rental property portfolio is their ‘pension’ or ‘retirement fund’.
Yet it is important to remember that if cash funds are required for retirement purchases, or significant care fees, attorneys may have tax to pay on the accrued gains on the property at 18 per cent or 28 per cent.
The longer game
The residence nil rate band (RNRB) was due to rise in line with inflation in April 2021, but both the nil rate band (NRB) and RNRB thresholds have been frozen until April 2026 following new government legislation.
The current NRB for a UK individual is £325,000. This represents the amount of the estate to be passed to the next generation without triggering any inheritance tax charge at 40 per cent.
There are important qualification factors for the RNRB including assets being passed to a direct descendent and the deceased having a suitable residence asset that has enough equity to utilise the allowance. This allowance is £175,000 this tax year and set to continue at this level in the medium term.
When combined a married couple, on second death, may have an allowance of £1 million of assets to be passed to the next generation without having to pay IHT.
While a very significant value individuals that have an extensive estate, specifically focused on property, this poses a particular issue.
Standing still in moving times
A couple who have a main residence, and two rental properties that come to a capital value of £820,000 in 2021/22 will find that at the 4.9 per cent growth rate these properties will reach the £1 million threshold by 2025-26.
This means that the full allowances have been used and anything else not exempt in the estate is liable to 40% inheritance tax.
When the Inheritance Tax Act 1984 (IHTA) was drafted it allowed for the NRB to increase in line with CPI unless Paliament decided otherwise. This has yet to happen in the last 37 years and as further confirmed in the Finance Bill 2021 further increases will not be implemented until at least 2026-27, along with possible increases in the RNRB.
Should the CPI increases be implemented from 2026/27 the allowances would increase with CPI (assumed to be at the targeted 2 per cent). This means a £1 million portfolio growing at 5.2 per cent per annum would have exceeded the growth in the nil rate band by £32,000 further driving up the IHT liability.
Catching up from the ’80s
Inheritance tax legislation is based on the 1984 Act of Parliament, in the time of shoulder pads and launching walkmans, however it has been modified and reviewed a number of times. The Office of Tax Simplification provided two reports, the second published in 2019, proposing some fairly radical changes to inhertiance tax and ways that it can be managed and processed.
It was widely expected that the Chancellor would adopt some of the proposed measures in 2020, however a pandemic put a dampener on this. So when speaking to clients the focus needs to be on flexibility which in some cases is not what bricks and mortar can give you.
For clients that are building up these portfolios and making fantastic rents planning ahead is key.
Looking at the current position and considering mitigating steps now saves money and worry. Clients can consider myriad options, including:
- life assurance for a growing liability with whole of life cover – rarely does the cost of the insurance increase as we age and buying now can save money and increase flexibility;
- considering using a family investment company in advance of too many accrued capital gains;
- looking at trusts before capital gains are too high and when there is time for funds to move out of your estate;
- investment in business relief qualifying funds or structures that allow assets to still provide an income, remain accessible for emergencies and liquidated quickly; and
- topping up a pension held outside of their estate for inheritance tax purposes.
In a changing landscape and a fast moving world this breeds uncertainty in the mind of a client. At times like this advice from trusted professionals is the best medicine to help an individual understand their position liability and options.
Inheritance tax is one that can be mitigated but can also be blindly walked into and it is never the wrong time to understand how you are positioned. It is worse to try and unpick elements in a crisis.
Andrew Goulter, consultant at Mattioli Woods plc