Measuring property rentals

This is looking at a portfolio of rental properties with mortgages and rental income:

The yield is an important parameter. This is the rent (excluding mortgage interest) divided by the current market valuation. An alternative is to deduct from the rent costs directly associated with the property such as maintenance and service charges, but not the mortgage interest since this is a financing choice.

The annual cash flow for a property is equal to the rental income less all costs relating to that property including mortgage interest.

Annual property appreciation, equal to the increase in market value over the year.

When evaluating a property ( annual cash flow + loan interest + property appreciation) should be divided by the current market value to give an overall yield, and this should be compared with annual price inflation.

Mortgages should be regarded as loan capital for the whole portfolio and so if a particular property has relatively high interest costs due to a high loan to value ratio or high interest rates, the property should not be judged a poor performer on the grounds of high interest costs. However the mortgage that is in place is linked to the property for operational reasons. A property having a poor yield may justify being kept if it is supplying a large anount of mortgage at a low interest rate. A property having a good yield but having a poor mortgage may warrant remortgaging if a better deal can be found. Legal costs, fees, arrangement fees, stamp duty make it more economic to amortise these costs over a number of years.

The concept of ROCE (return on capital employed) has limited significance. Where a property is bought with say a 75% mortgage (ie the capital employed is 25%) and the rental yield after interest is 2% and the annual property appreciation is 4% the ROCE would be 24% [ (2% + 4%) x 100 / 25]. The property is 'leveraged' or 'geared' four to one. This is the property investor's dream, but where there are losses, these can be leveraged as well. After a number of years the value of the property may have increased and as a result of this increased equity the ROCE will deteriorate. Thus too close attention to the ROCE could be misleading.

How are property rentals taxed?

The net rental income is taxable after deducting the personal allowance, currently at £10,000 and is assessed on the year to 5th April. The income is calculated according to accepted accounting principles which are regulated by the Financial Reporting Council. No national insurance is payable on rental income.


The fact that National Insurance is not payable on net rental income enhances the viability of this activity. If the activity were subject to National Insurance an additional 9% would be added to the tax burden up to around £44,000 income where it reduces to 2%. If National Insurance were to be introduced this would affect the differences between a limited company holding property and an individual. (A Limited Company does not pay National Insurance on its profits but pays corporation tax at 20% rising to 23% on higher profits)

Capital Gains Tax on Property

Of course, the two main sources of profit for a property-holding activity are net rental income and property appreciation. So having seen how the above helter skelter applies to rental income, how do the two regimes compare from the CGT (Capital Gains Tax) angle? For individuals, the CGT rates are 18% and 28% depending whether the higher rate taxes level has been reached and after deducting an annual exemption of £11,000 for 2014-15. For companies realising capital gains they would pay corporation tax at 20% (or 21% if the company had reached the main corporation tax threshold), then on the dividend paid to the owner there would be income tax subject to a tax credit on the dividend.

It is important to note that CGT is not applicable where a trade is carried out (that is, a trade of buying and selling property for profit). Where the gains are deemed to be the result of a trade the tax rules for sole-traders or limited companies apply and the tax considerations can be found here.

Capital gains tax has had quite a few changes recently but after the changes in rules from 22 June 2010 it has probably settled down now while the economy is recovering. For individuals there is an annual exemption of £10,100 then 18%, rising to 28% for the amount above the basic rate band of £37,400. The above graph shows the % of tax in the case of a limited company making the gain and an individual or self-employed person. In the case of the Limited Company the tax was mitigated as far as possible by declaring a salary of £5,715 and paying the remainder (after corporation tax) by way of a dividend. The limited company is undoubtedly disadvantages where CGT is concerned.

A limited company would pay corporation tax on its capital gains starting at 21%. To transfer the gain to the company owner in the most tax-efficient way, the Company owner would pay himself a salary of £5,715 and after corporation tax pay himself a dividend. The owner would need to pay some

So as a landlord why would I want a Limited Company?

Under the rules for taxation of property rental income for an investor only certain types of expenditure are allowed:-

• Interest and other finance costs
• Property maintenance and repair costs
• Heating and lighting costs, if borne by the landlord
• Insurance costs
• Letting agent’s fees
• Advertising for tenants
• Accountancy fees
• Legal and professional fees
• The cost of cleaners, gardeners, etc, where relevant
• Ground rent, service charges, etc.
• Bad debts
• Pre-trading expenditure
• Landlord’s administrative expenditure

Expenses such as office equipment, books, travel and susbistence, telephone and broadband are not provided for. A limited company can collect these costs and recharge them as a service charge. The limited company can award the owner a salary (such as a minimum £5,715) which can use the tax-free personal allowance efficiently. This salary can be recovered via a charge to the property activity, and even if as a result the property activity shows as loss, the loss can be offset against future profits. The limited company can be useful also where refurbishment is taking place with a view to selling a property at a profit. Here is an example:

A property is refurbished at a cost of £15,000 and the property is then sold realising a net gain of £40,100. There would be CGT payable of £5,238. (40100-11000) x 18%. If the owner had a limited company and charged £7,956 for his own labour and for managing the project (thus utilising his allowance) the amount of CGT would amount to £6,428. This gain could be paid as a dividend without further tax as it is below the higher rate tax threshold. Similarly, the work may straddle two years enabling the fee to be charged in each year, thus doubling the saving. In all cases amounts charged should be realistic in order to be acceptable by the taxman.

There are very little costs associated with having a limited company, the minimal cost being the annual return fee of £13. There are the annual returns to submit to HMRC and to Compamies House which are free but would involve a fee if you use a professional to prepare these.