One of the biggest life events to provoke a conversation about protection is when people buy a house and take out a mortgage.
This has been a constant for a long time in the UK.
Residential mortgages are a big catalyst for people taking out some form of protection cover.
Sometimes though, advisers find it a bit more difficult to position the idea of protection to landlords because the protection need is not quite as obvious.
People who purchase properties which they intend to rent out typically use buy-to-let interest only mortgages.
Often, their long term expectation is that property prices will increase and they will eventually cash in by selling them.
In the meantime, the rental income will fund the monthly mortgage payments and will also provide them with additional income.
Many landlords see the value of a property portfolio as a crucial part of their retirement planning.
However, in 2017, we saw the implementation of some new tax rules that meant over the next four years, the amount of mortgage interest which could be offset from rental profit reduces.
In this current tax year (2019/2020), landlords can offset 25 per cent of their mortgage interest from their rental profit.
From April 2020, this reduces to zero.
There is a tax credit relief available based on basic rate tax, but landlords will have to pay income tax on all of the rental income they receive meaning that many of them will pay more tax.
This new tax rule is going to change the landscape of the buy-to-let market.
How it normally works
For example, let’s say a landlord has five properties in their buy-to-let portfolio.
The properties are worth about £700,000 in total, but there are 5 lots of £100,000 interest-only mortgages, a total of £500,000.
Let’s say the interest rate on each buy-to-let mortgage is 3 per cent.
The total interest-only mortgage payments each month would be £1,249 or £14,988 each year.
Let’s say the income received on each property is £600 each month – in total this is £3,000 each month or £36,000 a year.
Clearly we can see that despite the large amount of mortgage debt and mortgage payments that need to be paid; the rental income will fund these mortgage payments and still yield a generous profit to the landlord.
A private landlord would typically complete a tax return each year and on it they would detail the income from their property portfolio and then detail all of their expenditures such as management fees and repairs, along with other expenses including the mortgage interest.
Income tax on the rental income profit is then charged at the normal rate of income tax.
But as you can guess, from April 2020, many private landlords with buy-to-let mortgages will simply pay more income tax on their rental income.
What if interest rates go up?
We know that we have been experiencing record-low interest rates for the past decade but inevitably, at some point, they are going to go up.
With this same example, let’s say the interest charged on those buy-to-let properties goes up to 6 per cent. I would imagine most people reading this would have experienced paying something close to that rate at some point in the past.
In my example scenario, the mortgage interest payments would increase to £2,501 each month or £30,012 each year.
This scenario looks a lot less attractive for a landlord.
If they can not offset interest-only mortgage payments from their rental income profit; this will result in significantly lower returns and then they will inevitably have to consider alternative options.
How will landlords adapt?
Let’s say a landlord runs their property business through a company rather than as a private venture; would these new tax changes I mentioned above apply? The answer is no.
If a company owns the property portfolio then the tax which is paid on the profit of the business is corporation tax.
At the moment, the corporation tax rate is 19 per cent but this is going to drop to 17 per cent in the next tax year (2019/2020) making the idea of holding properties within a limited company or specifically a SPV (Special Purpose Vehicle) quite attractive.
This is because a lot less tax will need to be paid which means a much greater net profit.
I must caveat that any landlords who do decide to move their private property portfolio across to a SPV would need to take proper advice because there are lots of implications to consider including stamp duty, lending criteria for new mortgages and various other considerations.
That said, at face value, it feels like these tax changes will nudge many landlords to move across to this type of model going forward.
Partners in business
Let’s look at a scenario where landlords set up a business to hold their property portfolio.
What are the protection opportunities that could arise for situations where people work together on a property venture?
Let’s say three skilled tradesmen get together with the idea of setting up a rental business.
They set up an SPV and they each invest £50k of their own money to buy their first property from an auction.
They buy the property with the cash they have pooled together with the intention of renovating it and putting it on the rental market.
Bob is a builder, Eric is an electrician and Paul is a plumber.
They do all the necessary work themselves and when the property is complete, they put it on the rental market.
The value of the property has increased, so they mortgage it and using those funds, they return to the property auctions to find their second property.
Their plan is to carry on doing this and build up their property empire.
Opportunities for Protection conversations?
What are the immediate protection opportunities up for discussion?
Control – Each partner will have a shareholding in the business to the value of how much they invested, so there is a question of how they keep control of their business if one of them dies or gets sick.
How would the surviving business owners feel if someone came into the business that they did not want to work with, because they had inherited their deceased business partner’s shares?
What if this new person has no useful skills but wants a say in how the business is being run?
Would the surviving business partners like to have control of their own destiny?
The answer to fix this problem is simple business protection.
This could be life insurance or critical illness cover, which would provide the necessary funds to allow the remaining shareholders the ability to purchase the shares of the other shareholder who might have died or been diagnosed with a critical illness.
Part of this solution would include a legal agreement which is designed to protect both parties – the business but also the family of the deceased or sick director.
Key people? – A scenario like this also suggests that all three business owners are key people.
If they perform duties which are essential to the running of the business, then sickness or death of one of them could affect profitability.
The answer to this problem is simple protection cover for each key person.
This could be life cover, critical illness cover or income protection; all of which are designed to allow the business the funds to protect their profits and perhaps bring someone into the business to perform the duties of their sick or deceased business partner.
Debts? – Another problem is those mortgages.
Simple loan protection in the shape of life cover or critical illness cover could be used to repay part or all of those debts – just like normal mortgage protection.
I also mentioned the initial funds that each partner put into the business when they set it up.
Each of those £50,000 deposits which were used to buy the first property are directors’ loans to the business.
In the event of the death of one of the business owners, how quickly would the family want that money back?
It is payable immediately, but it would be a problem if the surviving business owners did not have that kind of money available and they would not be in a position to pay it back.
Would this result in the surviving business owners needing to sell one of their properties to release equity? How will this affect things?
I think that over the next few years we’re going to see more landlords moving across to the SPV business model purely for tax reasons but this will open up a whole world of protection opportunities with buy-to-let landlords who have often been a tough nut to crack.
The trick for advisers is to not over complicate your process. Keep it simple and keep things clear.
Build your conversation around two key points: what is the problem and how do we fix it?
Problem: what specifically is the problem? What would happen if? What would the effect be?
Solution: what is the solution to fix this problem?
It does not need to be complicated, but this is another example of where proper financial advice is crucial for your clients.
By Vincent O’Connor
Source: FT Adviser