Freezing of income tax allowances … what can be done to mitigate the impact for landlords?
First Published: January 2023 | Available in: Property Articles Your Property NetworkThe 2022 Autumn Statement (the ‘Budget’ to you and me) saw income tax allowances and thresholds frozen. This will mean more tax will be paid as people are dragged into higher tax bands as their income rises. What can landlords do to mitigate the impact of this?
Key changes – quick summary
The Personal Allowance (£12,570), Higher Rate tax threshold (£50,270) and Pension Lifetime Allowance (£1,073,100) were frozen in March 2021, for 5 years. The 2022 Budget extended this by 2 years, to April 2028.
This means that these key thresholds will not be increased in line with inflation, and so as incomes rise more tax will become payable. In times of low inflation this is still an issue, but in times of higher inflation this can have a dramatic effect on the level of tax payable.
For example, assuming just a 4% average inflation rate for the 7 years in which these allowances are frozen, the following table shows what the allowances would have been:
This is known as ‘fiscal drag’ by economists, as the effect of not increasing allowances and thresholds in line with inflation is to ‘drag’ more income into the taxable bands. A landlord with income of £66,152 in 2028 should pay no more tax than in 2021, because the Personal Allowance and Higher Rate tax threshold has moved upwards by inflation.
However, the above demonstrates that £3,971 of income will become taxable (as the Personal Allowance hasn’t changed, but should been increased by £3,941, from £12,570 to £16,541), and £15,882 of this income will be taxed at 40%, rather than 20% (as the Higher Rate income tax threshold hasn’t changed, but should have been increased by £15,882, from £50,270 to £66,152).
The impact for a landlord with income of £66,153 is an increase in income tax of £3,970 (the tax due had the allowances not been frozen in the example above would be £9,922, but this becomes £13,892 (a 40% increase!).
This shows how powerful the compound effect of not increasing these tax allowances and thresholds in line with even modest (4%) average inflation is … meanwhile Government can still say that they haven’t increased tax rates (20% / 40%) … !
OK, that sounds worse that I thought – what can we do to mitigate this?
The key objective to mitigate the impact of the Personal Allowance and Higher Rate tax thresholds being frozen is to try to ‘fit’ the income within these bands as far as possible, so that a minimum amount possible of income sits within the Higher Rate tax band.
1. Reduce income by spending money pre-tax
For landlords exposed to Higher Rate income tax, spending money on repairs and maintenance effectively means 40% tax relief on such expenses. Of course, that doesn’t mean spending money on things that don’t need doing, but perhaps increasing the proportion of profits that are reinvested back into the properties themselves.
Or, spending money on computers and IT equipment, or hiring a letting agent, ensuring that business mileage and home office allowances are properly claimed … all reduce personal income down towards the Higher Rate threshold, and so minimise the amount of income taxed at that level.
2. Pension and Gift Aid contributions
Making personal pension contributions, and Gift Aid charity donations, extends the Higher Rate threshold and so means that more income can be earned before Higher Rate tax is payable.
e.g. all landlords can pay £2,880 into a personal pension scheme, which is then ‘grossed up’ by 20% Basic Rate tax relief, to become a gross contribution of £3,600. This is then added to the Higher Rate threshold (£50,270), so that the new ‘extended’ Higher Rate threshold becomes £53,870 … meaning an extra £3,600 of personal income is taxed at 20% rather than 40%. The same ‘grossing up’ applies to Gift Aid charity contributions.
3. Use a partnership to ‘spread’ income to family members
Many landlords operate their property portfolio in personal names in a way that means the Personal Allowance and Higher Rate threshold isn’t used in full for 1 person, but the other is paying Higher Rate tax (often as properties acquired over the years were done so in a mix of sole and joint ownership, so resulting in a mixture of ownership).
Forming a ‘simple’ (AKA ‘general’) partnership can allow property income to be shared between the partners in a more tax-efficient way i.e. NOT following the actual legal ownership of each property.
e.g. if the taxable incomes were £40k and £60k for each person, forming a partnership to allow the income to be split 50% each would save the Higher Rate tax on the top £10k of the person with the £60k income. Simple partnerships can be used to allocate property income in a more flexible way, such as if 1 person earns a salary, and so potentially up to 99% of the property income could be allocated to the other person(s).
Potentially adults children could also be brought into the partnership, to use their Personal Allowance and Basic Rate band, too (with the right advice).
4. Charging property management fees from your property company
For landlords who own properties in their personal name, and also have a non-VAT-registered property company, charging property management fees from the company to the personally-owned property portfolio can reduce personal income, and so potentially save Higher Rate income tax.
The fees charged are taxable in the company of course (19% currently), but if there is a 40% income tax saving on the personal side, there is the potential for a substantial tax saving. Care needs to be taken to charge a ‘commercial’ rate of management fees, and ensure these are either actually paid to the company or deducted from an in-credit Director’s Loan Account, but setting up this structure in the right way can be very beneficial.
5. Earn income via a company wherever possible
Given the aim of trying to make best use of the Personal Allowance and Basic Rate tax threshold (£50,270 in total), it often makes sense wherever possible for a company to be used to earn any extra non-rental income, so that it is taxed at the corporation tax rate rather than Higher Rate income tax.
6. Consider not taking a ‘Personal Allowance’ salary from your property company
Many landlords with a property company will pay themselves a ‘Personal Allowance’ salary, to use their Personal Allowance (this income being tax-free for the individual and the corresponding expense in the company being tax-deductible – saving £2,388 potentially (£12,570 salary @19% corporation tax rate).
However, if staying within the Higher Rate tax band is a priority, then it can make more sense to not pay a salary, so that property rental income is used to ‘fill’ the Personal Allowance, instead of salary. A year of State Pension entitlement can be achieved by paying Class 2 National Insurance (£158.05 per year, as at 2023).
7. Supplement income with regular capital gains
For larger-portfolio landlords, especially those approaching, or in, their later years, selling off properties to release tranches of equity can mean that retaining taxable incomes below the Higher Rate threshold is possible, as the capital released from property sales is used for personal spending, along with the taxable income.
Capital gains tax is payable on capital gains made after the annual exemption, but even at the residential CGT rate of 28%, this can make overall sense as it combines a common desire to wind down a portfolio in later life with the desire for maintaining an income level sufficient to enjoy a good quality of life, which may not be the case if income is ‘restricted’ to the Higher Rate tax threshold.
8. Pay children and family members for work performed
Many landlords have family members, including children aged 13 and over, who help to run the property rental business, and are paid for their time and effort. Rates paid must be on a sensible commercial basis and for work actually done, however these costs in turn reduce the landlord’s income, potentially saving Higher Rate income tax as a result.
Usually the amounts paid fall within the Personal Allowance for children up to age 17, and from 18+ a person becomes an adult in their own right and so could be paid more, and even join the family property partnership, so enabling the family to utilise more of the Personal Allowances and Basic Rate band across the family.
A payroll scheme could be set up to pay up to the Personal Allowance level typically, whereas otherwise salary payments would be limited to the ‘Lower Earnings Level’ (about £6.5k per tax year), which is the maximum salary that can be paid without a formal payroll scheme in place.
9. Pay interest on Director’s Loan Accounts & take tax-free dividends
The Savings Allowance (£1,000 or £500 for a Basic / Higher Rate taxpayer, respectively) allows some interest to be earned tax-free, or allows for interest to be charged to a company if there is an in-credit Director’s Loan Account. Similarly the £2,000 per dividend allowance should be taken wherever possible each year, albeit this is reducing to £1,000 in 2023, and £500 in 2024.
10. Supplement taxable income by drawing tax-free amounts from ISAs and pensions
If the aim of the game is to keep taxable income within, or close to, the Higher Rate tax threshold, supplementing taxable income by drawing off funds from an ISA could make sense – especially as the current-year ISA allowance can be paid in, drawn back out, and then paid in again during the same tax year (so allowing some flexibility in paying into and out of an ISA).
For landlords who have a pension and are old enough to access it, drawing off the tax-free 25% amount is also a way to supplement taxable income with non-taxable pension drawings. Leaving the remaining 75% within the tax-free pension wrapper allows the remaining funds to remain invested and so grow tax-free.
Summary
The freezing of the income tax Personal Allowance and Basic Rate band for a total of 7 years will mean many landlords and property investors will potentially pay substantially more income tax, especially as rents and inflation are rising currently.
This article has highlighted a few options that may be useful for landlords with different circumstances to mitigate – although probably not eliminate – the impact of the freezing of these key allowances.
Remember, in the words of Charles Darwin… ‘It is not the strongest, or most intelligent, of the species that survives. It is the one that is most adaptable to change’.