By Simon Misiewicz
Are you a higher rate taxpayer?
Do you ignore the fact that you have paid employment tax when you invest in residential properties?
The problem — paying tax on your employment income to invest in property
Many higher rate taxpayers work very hard for their earned income and are taxed at 40%/45%. There are many people that take their remaining cash, after a large chunk of tax has been deducted, and invest in residential properties.
The issue as I see it may be better explained in the below example:
John buys a property and aims to make money by renting it out. He buys a property below market value and feels that he can generate about 15% return on investment (ROI). Here is the breakdown of his numbers:
- £100,000 house
- £25,000 deposit (25% of the purchase price)
- £30,000 refurbishment costs
- £55,000 cash invested in the project
He makes £750 rental profit per month, which equates to £9,000 per year. To obtain the ROI we divide the £9,000 by the £55,000 amount of money invested and times it by 100.
- £9,000/£55,000 X 100 = 16.3%
As you can imagine, John is very happy with these numbers.
John is a higher rate taxpayer. In order to get the £55,000 out he would have been employed and paid tax on this money. Lets take for granted that the £55,000 was taxed at 40%. This means that John would need to earn £91,667, which is therefore the actual cash invested.
The property profits will also be taxed at 40%. Thus:
- £9,000 profit made in the year
- £3,600 tax at 40%
- £5,400 net profit after tax
The real ROI is therefore :
£5,400/£91,667 X 100 = 6% ROI (10% less than John had assumed).
Would you invest in this property now that you have this additional information at hand? I wouldn’t.
Can you see how much tax you actually pay when investing in residential properties?
If you have answered yes to these questions, then keep reading for a way around this.
The solution — get HMRC to invest in your residential properties
The solution is to prevent paying tax at the front end on your employment income. This may be done by investing money into a pension. There is a vehicle that allows you to purchase commercial and residential properties using pension money, indirectly.
You would be right to assume that pension money can only invest in commercial properties but there are indirect vehicles that may be used to draw money from your pension to invest in both commercial and residential properties.
As the example above shows, John is paid a salary of £91,667 but instead of allowing money to be paid directly to him he invested £55,000 directly into a pension.
HMRC kindly sent John a cheque for the tax credit for the £55,000 that he paid into his pension. How would you like to receive a cheque from HMRC for £22,000 (40% of the £55,000 investment)?
John then takes a loan of 40% from the pension into a limited company that invests in residential properties. An agreement is struck for the limited company to pay the pension 7% interest. Remember that the loan interest paid into YOUR pension is tax-free, as is the capital growth.
The limited company can therefore invest the £22,000 into residential properties without having employment tax deducted at source.
Indeed, the £22,000 loan from the pension company is the same amount of money that John receives from HMRC. He can also invest the £22,000 tax refund from HMRC and use that as a loan into the limited company. The company now has £44,000 and it has not suffered any employment tax.
Next steps — invest in properties with a lot more tax efficiency
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