Property Investors: Convert
Income to Capital Gains
Convert Income to Capital Gains to Save Tax
Many property investors are currently earning handsome rental profits because they have either low variable rate or tracker mortgages. The lucky ones have no borrowings at all.
Unfortunately, many of these investors will be paying up to 40% tax on their rental profits; possibly 50% from next April.
The easiest way for a property investor to convert heavily taxed rental income into lightly taxed capital gains is by borrowing to invest in more property.
This is best illustrated with an example.
Joan has £100,000 and uses it to invest in a single buy-to-let flat. She has no borrowings. The flat produces a rental profit of £5,000 per year. After income tax at 40% she is left with £3,000. Over the next 10 years the flat grows in value by 3% per year and the rental income grows by 3% per year. She reinvests her rental profits and earns 3% per year after tax.
After 10 years the property will be worth £134,000 and her accumulated net profits will come to £39,000 – total assets £173,000.
Her friend Paul also has £100,000 but uses it to invest in four buy-to-let flats costing £100,000 each. He borrows the extra £300,000. The three flats produce rental income of £20,000 per year but all of it is used to pay mortgage interest (he goes for a 5-year fixed rate to reduce risk but the higher rate eats up the rental income on all four properties).
Paul has given up rental income in return for capital growth on a much bigger chunk of property. His mortgage interest is tax deductible, so he is effectively converting income into capital gains.
The four properties rise in value by 3% per year and are worth a total of around £538,000 after 10 years. He sells three of them to pay back his borrowings and get his hands on some cash. His total profit is £103,000, but the resulting capital gains tax bill is just £16,000, thanks to the 18% tax rate and his annual CGT exemption.
Paul is left with a single property worth £134,000 (just like Joan) but £87,000 in the bank – total assets £221,000.
In summary, Paul, the heavily geared property investor, ends up with almost 30% more money than Joan.
What this example shows is that even when property prices are rising very slowly – by just 3% per year – it is possible to boost your returns significantly using gearing and convert heavily taxed rental income into leniently taxed capital gains.
If property prices were to rise by, say, 5% per year, Paul could end up with over 50% more money than Joan.
But what about market risk? It hardly needs spelling out. Joan has no borrowings but Paul is in hock to the tune of £300,000. A 25% drop in property prices would wipe out his investment altogether. A sharp increase in interest rates could become impossible to service out of the properties’ rental income.
Strategies for Stock Market Investors
Stock market investors can avoid income tax and capital gains tax altogether by using ISAs and SIPPs. If you have already used up your allowances for the year, however, your investments will be taxable.
Most heavily taxed will be your interest and dividends. Most leniently taxed will be your capital gains.
The obvious solution is to invest for capital gains rather than income. So out go corporate bonds which pay interest and out go defensive shares with fat dividend yields. In come growth stocks, like tech companies, which often pay low or no dividends.
The market risk is clear once again: corporate bonds and defensive stocks are generally considered far less risky than growth stocks.
I’ve also seen zero dividend preference shares touted as a way of converting income into capital gains. An investment trust may issue zeros for 100p, promising to repay 150p in 7 years time, providing this is fully covered by the trust’s assets. This return is subject to capital gains tax.
And the market risk? You may remember the split capital trust scandal several years ago when investors lost over £600 million by investing in similar instruments. Apparently, however, zero dividend preference shares offer better asset protection than the old split capital trusts.
Another way of converting income into capital gains is to set up your own investment company to hold high income securities which would normally be taxed at 40% or 50% in your hands. The corporation tax rate for investment companies is just 28%.
Saul has £200,000 to invest in high income earning securities paying 7% per year. Because he is a top earner he faces an income tax rate of 50% next year. He decides to set up a company, transfers the money in and invests it. His money grows by 5.04% per year (7% less 28% corporation tax) and, after 10 years, has grown to £327,000.
If Saul held the investments personally and paid 50% tax each year he would end up with just £282,000. Using a company he is £45,000 better off.
If Saul wants to get his hands on all of the money, he can liquidate the company. This would normally result in capital gains tax becoming payable on all of his accumulated income and explains why using a company is a way of converting income into gains.
Even after paying this tax, Saul could still be up to £24,000 better off. Alternatively, he might perhaps avoid it by emigrating before liquidating the company.
Using an investment company is not without drawbacks and risks, however, such as higher accountancy fees and the danger of future changes to tax legislation.
Worst of all, HMRC may sometimes be able to tax the final distribution on liquidation of the company as a dividend rather than a capital gain. In Saul’s case, this would lead to a final tax charge of around £46,000, thus wiping out the initial advantage of the investment company.
Nevertheless, an investment company remains worthy of consideration if you have significant surplus assets and are content to leave them in the company.