Buy to let vs Stocks & Shares ISA: why the pendulum has swung

The benefits and dangers of buy-to-let investing with investing in equities.

Article updated: 8 February 2017 12:00pm Author: Michael Baxter

House buy

Changes

The tax treatment of buy-to-let is set to change – and if you are a higher rate taxpayer, this could have implications.

Alas, as is so often the case with tax, you can’t explain the change in one sentence.

At the moment, interest on a mortgage is counted as a tax-deductible cost within a buy-to-let portfolio. From the next financial year, this is going to change, but the change will be phased in gradually. Once it is fully phased in, it will no longer be possible to offset interest against revenue, but you will get a 20 per cent tax rebate on interest.  This means that someone paying tax on the 20 per cent band, will be no worse off. They will be unaffected by the change, it is just that their tax will be calculated using a different method. But a higher tax payer will, after getting the 20 per cent tax rebate back, effectively be paying 20 per cent tax on mortgage interest. An additional rate tax payer will pay tax at 25 per cent.

As I say, the change will be phased in gradually, next year. In 2017/18 only 25 per cent of mortgage interest will be subject to this change. In the year 2018/19, 50 per cent of mortgage interest will be subject to the change, in the year 2019/2020, 75 per cent of interest will be subject to the tax changes, and in 2020/21, 100 per cent of mortgage interest will be subject to the changes.

For a higher rate tax payer, the effective tax rate on interest within a buy-to-let portfolio will be as follows:

Slide to view more
Year
Percentage of mortgage interest subject to tax and counted as taxable income in per cent.
Percentage amount of tax paid by individual in the 40 per cent tax bracket on mortgage interest, before tax relief
Tax relief in per cent
Percentage amount of tax paid by individual in the 40 per cent tax bracket on mortgage interest, after tax relief
2016/17 0 0 0 0
2017/18 25 10 20 5
2018/19 50 20 20 10
2019/20 75 30 20 15
2020/21 100 40 20 20

What this means

There are two important implications for investors who might be considering moving into property.

Implication number one: watch carefully even if you are a lower tax rate payer. The change in the way the tax is calculated has a subtle effect. It means that a lower rate tax payer may find themselves falling into the higher tax bracket.  Let’s say your annual income means you earn £5,000 less than the rate that would put you into a higher tax bracket. And let’s say your buy-to-let portfolio yields an additional £10,000 a year net of other costs and interest is £5,000.  Under the old system, you would continue to pay tax at that lower rate. With the new system, all of the interest is counted as tax deductible income, so you would exceed the tax threshold by £5,000. Once the changes have been phased in, you would pay tax on this extra £5,000 at say 40 per cent, and get a 20 per cent rebate, meaning that your tax bill will be £1,000 higher.

Implication number two: I calculate that in order to breakeven from the year 2020/21 onwards, once the new tax rules come into force, then all else being equal, you need to ensure that your mortgage payments are less than 83.33 per cent of your net yield.

Working on the assumption that costs associated with buy-to-let, for example maintenance, agent fees, to cover arrears and periods when the property is empty, are 35 per cent of yield, this means that you need to ensure that interest is no more than 54 per cent of yield.

Higher rates

Let’s say interest rates go up between now and the year 2020/21. And let’s say that the interest on a mortgage rises from three to four per cent. Or by 1.33 per cent. By my maths, that means you need to ensure that when you start the portfolio, at an interest rate of three per cent, to ensure you break-even once the new tax changes are fully implemented and once interest rates rise to four per cent, you would need to ensure that interest is no more than 40 per cent of yield.

And finally, to take one more scenario, if rates rise to five per cent, then to break-even by the year 2020/21 you would need to ensure that interest accounts for no more than 33 per cent of the yield.

Other tax issues

But there are other tax costs associated with buy-to-let, for example, a higher rate tax payer pays capital gains tax at 28 per cent, subject to £11,100 allowances and stamp duty is much higher on property than on equities.

The pendulum

It seems to me that the pendulum has swung.

All else being equal, and assuming similar returns, the big advantage of buy-to-let over equities is that it allows leverage and thus you can multiply any growth in value.  On the other hand, leverage is risky, and in the event that house prices fall, losses are also multiplied.

Equity investing had the advantage that is provides greater liquidity and is much less hassle.

But thanks to the change in the tax treatment of buy-to let, the degree of leverage needs to be much lower, thus significantly lowering the one big advantage of this form of investing, and thus ceding the advantage to equities, especially when you factor in lower capital gains tax rates and stamp duty.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

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Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.