The income equation – why property is such a powerful investment
When you invest in property, you do so to improve your lifestyle. It’s a great asset to do this, whether by capital gain or rental income, or both. In this article, you’ll be introduced to the concept of rental income. You’ll learn how to measure your income against other properties and other assets. You will also learn some tax basics and some factors that affect your rental income.
What is rental income?
Let’s start with the most basic question: what exactly is rental income?
Simply put, it is the gross amount you receive when you let your property to tenants. Gross means before any costs and expenses – such as property management, mortgage payments, maintenance, and so on. Also, before you pay any income tax.
How do you know that it’s a good income?
This is one of the most important questions you should ask yourself when investing in buy-to-let. A mistake that rookie investors make is thinking that £1,000 income is better than £500 income. Sure, it’s more, but that doesn’t mean to say it’s better. Let me explain…
Jack has invested £300,000 and receives £1,000 rental income each month. His girlfriend Jill invested £100,000 and receives £500 per month in rental income. For the sake of this example, we’ll consider that they have no associated expenses.
While Jack’s rental income is higher, Jill’s capital is working harder for her. Jack receives £12,000 per year in rental income. This means his capital is yielding 4% (rental income/capital invested x 100).
The rental yield on Jill’s investment capital is far higher. She receives £6,000 per year in rental income – half of Jack’s income. But she only invested a third as much. Her rental yield is 6%.
The rental yield also helps you to compare buy-to-let opportunities against other income-producing assets, like the interest you might receive on cash in the bank (around 1%). Or the dividends you receive on shares (around 4.5% on the FTSE 100).
What is ‘real yield’ on a buy-to-let property?
Here’s where things get a little more interesting. So far, we’ve discussed gross rental yield. Jill’s 6% yield is pretty good. But it may not be the whole story.
Let’s consider that the property she bought cost £100,000. She didn’t buy it with cash. Instead, she used a buy-to-let mortgage of £70,000 and paid a deposit of £30,000. The interest rate on her mortgage is 4%. Here are how the numbers stack up:
|Rental Income Net of Mortgage||£3,200|
Jill is left with only £3,200, but she has only invested £30,000. Her real yield has soared from 6% to 10.7%. This is the power of leveraging in property investment.
What else affects your net rental income?
Of course, you will have other costs and expenses to pay from your rental income. These might include repairs and maintenance, landlord insurance, and property management costs. Repairs and maintenance bills are generally higher for older properties.
In Jill’s case, let’s say that property maintenance costs are £500. Landlord insurance is only £100, and property management costs are 10% of the gross rental (£600). Jill’s net income is now £2,000. Her real yield after all expenses is now 6.7%.
How is buy-to-let rental income taxed?
When calculating your income tax liability, you are charged income tax on the gross rental income less allowable expenses. Allowable expenses include items such as:
- Repair and maintenance costs (e.g. repairs to electrical faults and gas pipes, broken windows, redecorating, etc.)
- The replacement cost of items
- Property management costs
For tax year 2019/2020, you can also deduct 25% of your mortgage interest payments from your gross rental income. You claim tax relief at a basic rate on the remaining 75%. From 2020, you may only claim tax relief at a basic rate on 100% of your mortgage interest payments.
Once you have deducted these costs, you are left with your taxable gross rental income.
Let’s look at what this means for Jill in 2020/21:
|Gross Rental Income||£4,800|
Jill will be taxed at her marginal rate on £3,800 and claim tax relief at the basic rate of tax on her mortgage payments of £2,800.
If Jill is a basic rate taxpayer, her net income will be:
|Gross Taxable Income||£4,800|
|Income Tax Liability (@20%)||£960|
|Tax Relief on Mortgage Interest||£560|
|Total Rental Income Net of Income Tax||£1,600|
What about rental income in the long term?
Investing in buy-to-let property is a long-term strategy. Over time, the value of your rental income increases. Let’s say that, over the next 10 years, Jill increases the rent she charges her client by 2.5% each year. After 10 years, the monthly rental income would be £640. Annually, this is £7,680. That’s an incredible 25.6% on her original capital invested.
If Jill’s costs and tax position remain broadly unchanged (except for property management fees increasing because rental income has increased), her net income would be:
|Gross Rental Income||£7,680|
|Gross Taxable Income||£6,100|
|Income Tax Liability (@20%)||£1,220|
|Tax Relief on Mortgage Interest||£560|
|Total Rental Income Net of Income Tax||£2,640|
When you invest in property, you make money via increases in the value of your property and by rental income. Most investors invest with the aim of the rental income at least covering costs.
Over the long term, increasing the rent by the rate of inflation more than protects your income from inflation. Your real yield on your original capital invested grows.
In our example, Jill’s net income (after-tax) has increased from £1,600 to £2,640 in only 10 years. That’s a growth rate of more than 5% per year.
In our next article, we’ll look at the elements of maximising rental income.
Live with passion