I have been posting on numerous forums about the introduction of equity loans into the UK buy to let mortgage market, a common question is the tax treatment.
Equity loans do not attract interest in the normal way, there are no regular monthly payments. One UK lender, funded by USA equity house JC Flower & Co. (a leading financial services investment company with funds in excess of £5billion) has entered the UK market and others may follow. Their return on investment is earned when the loan term expires or or sale or refinance of the property, whichever is sooner. Their return is capital plus a share in capital appreciation equal to double their investment. For example, if they provide top up finance of 10% of a property value their return with be 20% of the increased capital value plus their investment when the funding is redeemed.
As you may know, I was previously a former commercial finance broker. When I was practising I was renowned for digging into complex funding, tax and legal structures to explore opportunities and threats which others may never have considered.
Note to all – I no longer provide advice and this post must not be treated as advice.
The tax treatment of the redemption of BTL equity loans will be very interesting.
Let’s use this example. Equity loans can sit over and above traditional interest bearing mortgages but for the sake of simplicity I have based the following example on equity funding only.
Property value at outset £100,000
Equity loan at outset £20,000
Property value at sale £200,000
Capital gain £100,000 (or is it and if so how is it shared? – see below)
Equity loan capital repaid £20,000
Profit on Equity loan to lender £40,000
Now does the £40,000 profit on the equity loan to the lender reduce the owners capital gain to £60,000 or is the owners gain still treated as £100,000?
The lender operating the first of these schemes has already stated they will bill their return as interest at the point of loan redemption. However, that’s not to say HMRC will see it that way, only time will tell. Therefore, my suggestion to all landlords considering this type of finance is to plan for the worst and hope for the best in terms of tax treatment. As has been proven many times, the law says you can call something pretty much whatever you like but case law or legislation will determine what it really is. Case in point, advance rent or deposit? – see Johnson vs Old
So will profits made by equity lenders need to be used to offset rental profits? If so there could be a substantial paper loss created in the year of redemption. Unused losses may be rolled forward, assuming losses are made, but such losses are only offsettable against future rental profits. No problem, in fact potentially very advantageous, IF you continue to make rental profits going forward. However, if this was your only property you may be stuffed by having to pay CGT on the full £100,000 of gain and not being able to utilise the carry forward losses. Note that rental losses can not be used to reduce other taxable income.
I can’t see HMRC allowing landlords to choose how they apply the lenders return to suit their individual circumstances, i.e. as either interest or a share of capital gain, but we can live in hope, not that that’s a good strategy of course! If HMRC do allow a choice to be made that would be utopia from a tax planners perspective 🙂
What I would suggest to all considering equity loans is that they should plan for the worst case tax scenario and hope for the best case tax scenario. In other words, make decisions based on the worst case tax scenario and if that works then fine. Obviously there are many other aspects of the deal to consider too which is why I am an advocate of taking professional advice as opposed to taking a short sighted approach and simply jumping into deals unadvised just to save initial fees.
If you are a portfolio landlord who makes good rental profits then treating the lenders return as interest could be extremely tax advantageous if the tax regime remains as it is today. This is because income tax rates are greater than capital gains tax rates for higher rate tax payers.
Therefore, for landlords who will continue to make rental profits, post redemption of their equity loans, this is particularly attractive in my opinion. At worst, if HMRC decide to treat the lenders returns as capital gains, landlords will pay a lower CGT bill and not be able to offset interest. For a landlords with no ongoing rental profits post redemption of an equity loan, having the lenders return treated an interest charge is highly unlikely to be attractive whereas having the returns treated as capital gains will be far better for them.
If, of course, your equity loan is secured against your private home then no CGT is payable on sale anyway.
Tax is not the only consideration.
I have listed 11 good reasons for considering the product and 9 downsides in my main post about equity loans. That’s not to say that everybody should think equity loans are the best thing since sliced bread just because my list of pro’s and cons is 11 vs 9, it doesn’t work that way. The reasons for NOT doing something can be very different to reasons FOR doing something, they are not necessarily like for like considerations. For example, I also prefer a strategy of high gearing combined with high liquidity over a low gearing strategy because that’s what suits me and my attitude to risk. It does not mean that people who prefer a different strategy are either wrong or right, it just proves we are all different, hence we have other preferences such as careers, holidays, cars, films, food and where we live.
For further information and discussion about equity loans please CLICK HERE.