Buy-to-let is becoming less attractive for landlords.
In April 2017 came a radical change. The government committed to entirely phasing out buy-to-let mortgage interest tax relief.
Prior to this change in legislation, landlords only paid income tax on their net rental income. For landlords with interest-only mortgages, this meant that they could effectively claim all their mortgage repayments.
But from April 2020, landlords will be unable to deduct mortgage interest. Instead they will only receive a tax credit of 20%. As a result, higher or additional-rate taxpayers won’t get all the tax back on their mortgage repayments, as the credit only refunds at the basic rate. It could also trigger higher income tax thresholds, because you’ll need to declare the income that was used to pay your mortgage on your tax return.
Let’s look at an example. A higher-rate taxpaying landlord receiving £950 rent a month and paying £600 towards their mortgage would have received a tax bill of £1,680 prior to April 2017. By comparison, from April 2020 the tax bill would be £3,120.
The trajectory of legislation and what it means for clients
The government has acted to make buy-to-let more expensive for new purchasers and existing landlords.
A client with a buy-to-let portfolio not only faces a loss of tax-relief on mortgage interest, but more taxation when buying or selling buy-to-let properties.
A higher rate stamp duty surcharge on purchasing additional homes came into force in the 2016/2017 tax year. Currently this can be between 3% and 15%, depending on the value of the property.
And now a draft Tenant Fees Bill aims to restrict lettings agents from charging fees to tenants. It could begin to impact landlords soon, as agents may look to increase the fees they charge to landlords to make up the shortfall.
You may have clients receiving rental income and facing this difficult landscape. For those who are comfortable with the risks, they could benefit from tax-efficient investments like VCTs.
Helen has a tax problem
Say you have a client. Let’s call her Helen.
Helen and her husband, Daniel, have been married for 30 years. They are looking forward to retiring in ten years’ time. Daniel pays higher rate tax and has adequate pension provision. Helen, on the other hand, invested in property to help fund her retirement.
Helen earns £30,000 of rental income after costs from her properties, and she has other income up to her personal allowance. She expects to pay £6,000 income tax this year. Both Daniel and Helen are keen to enjoy a tax-efficient income during their retirement, but Helen doesn’t feel ready to sell her properties. She doesn’t want to face a large capital gains tax bill of 28%.
Helen talks to her financial adviser. He makes an assessment based on her risk profile, investment time horizon and attitude toward smaller company investing. She is willing to take on risk and to hold her investments for five years or more.
Based on the results of his assessment, her adviser suggests a VCT.
What are VCTs and how do they work?
Smaller companies need investment to help them grow. Venture capital is about supporting small businesses that have great potential. VCTs seek out those companies that could become household names and give them the funding they need.
Provided your investment is held for at least five years, up to £200,000 qualifies for 30% income tax relief in any single tax year. VCT shares incur no capital gains tax when sold, and there is also the potential of tax-free dividends. This may be an attractive offer for clients who are being exposed to the worsening tax-treatment of buy-to-let.
How Helen can make VCTs work for her
Helen’s adviser suggests investing £20,000 of her annual rental income in a VCT and putting the remaining £10,000 in an Individual Savings Account (ISA).
By investing in a VCT, she should also be able to claim income tax relief, while any dividends and capital gains should be tax-free. The upfront income tax relief Helen qualifies for (£6,000) would cancel out the annual income tax she’s required to pay on her rental income.
Helen needs to fully understand the benefits and risks of VCTs before she makes an investment decision. She needs to know that VCTs are high risk investments and should not be used for their tax benefits alone.
If Helen needed guaranteed income, could not tolerate loss, or was uncomfortable losing immediate access to her money, then a VCT would not be a suitable option for her.
Understanding the risks of VCT
It is important to recognise that the value of a VCT investment, and any income from it, can fall as well as rise. An investor may not get back the full amount they invest.
VCT shares are, by their nature, high risk. Their share price may be more volatile than those of other companies listed on the London Stock Exchange, and they may be harder to sell.
Tax treatment depends on individual circumstances and may change in the future. Tax reliefs depend on the VCT maintaining its VCT-qualifying status.
Supporting the next generation of British businesses
The UK has a great track record for producing small, fast-growing businesses, and these firms are important to the economy. High growth small businesses (HGSBs) – a category that includes many companies backed by VCTs – make up less than 1% of UK firms, but create as many as 3,000 new jobs every week .
VCTs play a key role in providing early stage companies with the finance and expertise they need to succeed. As a result, between 1995 and 2014 the average VCT-backed company had achieved turnover growth of 183% since initial investment . At the same time, they offer investors an opportunity to access this growth within a wider portfolio of investments.
VCTs are growing in popularity
VCTs are in high demand. Investors put £728 million into them in the 2017/18 tax year, an increase of 34% on the previous year . They are powerful planning tools, so investors will be using them for a variety of reasons. But it’s likely that many are using VCTs within a retirement strategy because their buy-to-let income stream is being squeezed.
Taking the next step
Given the unfavourable tax treatment of buy-to-let, and the visibility over its future treatment, it is important to address clients’ approach sooner rather than later.
If you have clients with buy-to-let portfolios, then it makes sense to consider a VCT.
It also makes sense to start talking to providers now, so you know what’s available.
Note that VCTs have finite fundraising capacity, and the most popular ones can fill up quickly. Start your planning early to make it more likely your client can invest in their preferred VCT.
If you have any clients you think could benefit from investing in a VCT, you can speak to an Octopus business development manager by calling 0800 316 2967.
You can find out more about the products Octopus offers on our VCT page.
 Source: Centre for Economics and Business Research, 2016
 Source: AIC Survey, 1995 – 2014
 Source: AIC Press Release 10 April 2018