Friday 11 March 2016 4:57 am

Buy-to-let tax changes: A perfect storm for landlords and tenants

Upcoming tax changes have ignited debate about the role private landlords should play in meeting the UK’s housing needs. Focus has fallen on buy-to-let but, as the Institute for Fiscal Studies, among others, has noted, landlords are taxed much less favourably than home owners.

Following last year’s Autumn Statement, which outlined plans for an additional 3 percentage point levy on stamp duty when buy-to-let properties are purchased, I was asked by the Residential Landlords Association to produce an independent report on what effects these changes and the earlier announcement of restrictions to mortgage interest relief and deductible allowances would have.

I estimate that higher rate income tax-paying landlords who own about 40 per cent of market-rented housing in the UK are likely to be adversely affected. The negative impact on post-tax returns is also likely to be high. My modelling suggests that landlords paying the basic rate are likely to see average returns falling by around 10 per cent as a result of the changes, while returns for higher rate taxpayers look set to fall by between 30 and 40 per cent because of the added effect of the loss of financial cost relief.

In a period in which the image of landlords continues to take a battering, many will no doubt ask “so what?” Surely landlords can afford to take the hit given alarmist headlines about rising rents? Delve deeper into the statistics, however, and it becomes clear that things have not been as rosy for landlords as many suggest. Returns from rental income have for many years been compressed as a result of house prices rising faster than rents. As figures from the Office for National Statistics and LSL Property Services suggest, between the crisis year of 2008 and late 2015, average rents increased by 21 per cent – not much more than general price inflation over the period– while house price growth was 45 per cent. There was a similar divergence in the boom years prior to 2007. Only continued strong rises in house prices would make investment attractive for many landlords under the new tax regime and that outcome is both undesirable and unlikely.

But what does all this mean?

Tax changes that lead to lower returns threaten to reduce investment significantly in much-needed new homes to rent, especially when returns from other assets may start to rise. There is already a shortage of properties to rent in many areas and the consequence can only be higher rents. This will inevitably make it harder for first-time buyers to save the funds required for a deposit to buy a home of their own.

But will homes be freed up for first-time buyers? This is less likely than has been suggested as many rental properties, such as houses in multiple occupation, are often unappealing to this group, as are the areas where renting is concentrated. The main competitors faced by first-time buyers are existing home owners, whose tax breaks and high own-equity make them strong players in the market-place.

Unfortunately, landlord returns in the future may be so low as to threaten the considerable progress achieved in recent decades in improving housing quality and professionalism in the private rented sector. As the government implements its tax changes, my analysis suggests that future post-tax rental returns may be insufficient to incentivise good quality repairs, as for many investors post-tax annual cash flows will often not cover the costs of on-going major repairs and improvements.

Given the growing tax wedge that will result between larger and smaller landlord net returns, many larger landlords are likely to sell properties and smaller ones may well buy them. Larger landlords can devote more time and expertise to their businesses than smaller ones and, given this changed investor profile, landlords will overall be less equipped to offer a professional service. Landlords whose total incomes fall within the basic rate tax band often need all their rental income for their own immediate use, and so are less able to deal with unexpected out-of-pocket expenses and are more financially vulnerable in what is a risky market-place.

Converting to corporate status offers little advantage to most tax-stretched landlords once the resultant taxation of dividends is taken into account. Furthermore, large-scale build-to-let investors are not necessarily the answer, as they require significantly higher target rates of return than typical private landlords. Those extra required returns can only be funded out of higher rents or additional tax breaks.

With the Budget now less than a week away, what can be done?

A tax break for larger property holdings would encourage professionalism among individual private landlords.

An offer of significant tax breaks for membership of quality assurance schemes would support the professionalism of the sector and help to address the potential impact of the tax changes on the quality of rental housing.

Finally, prudent landlords build up sinking funds for the periodic major repairs that inevitably arise with housing. The introduction of tax reliefs related to them would incentivise this essential underpinning of building quality and bring the UK into line with equivalent depreciation allowances available in many other countries.

Such measures would offer respite from some of the unintended consequences of the proposed and soon to be implemented buy-to-let tax changes.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.