Beware the remortgaging tax trap
In the current environment of low-interest rates and poor returns on annuities, many retirees are turning to equity release to help fund their retirement. This strategy hasn’t been available to property investors for years, but a pensions company has now entered the market and is offering lifetime mortgages (as this type of equity release is also known) to buy-to-let landlords.
In this article, you’ll find out the advantages of releasing equity from your property portfolio. I’ll also explain the equity release tax trap that affects property investors who raise retirement funds this way.
What is a lifetime mortgage?
Traditionally, a lifetime mortgage is a way in which you can release equity from your home without having to sell and move. It’s like remortgaging, with the difference that the loan doesn’t have a defined repayment date.
Let’s say that Fred and Mable, both retired, live in a house worth £300,000 on which the mortgage has been paid in full. Their current pensions don’t pay enough income to meet their outgoings, and they would like to take a holiday of a lifetime before it’s too late. By taking a lifetime mortgage on their home of, say, £200,000, they could spend £20,000 on their dream around-the-world trip, and invest £180,000 in creating extra income.
There are various repayment methods available to Fred and Mable. These range from no monthly payments to monthly repayments, which include repayment of capital. When they die, the outstanding loan (plus any interest owing) will be paid by Fred and Mable’s estate.
The release of equity, creation of income, and ability to remain in the home are big advantages for many retirees. Now similar benefits are available to property investors with buy-to-let portfolios.
Why haven’t property investors been able to take out lifetime mortgages before?
Extending lifetime mortgages on buy-to-let properties are riskier than providing them in people’s homes. For example, there can be complications with existing tenants or state of repair could be an issue. Unravelling a property portfolio between several beneficiaries on death can be complex. Because of such matters, lenders and other financial institutions have shied away from offering lifetime mortgages on property portfolios.
What are lifetime mortgage products available on buy-to-let properties now?
Retirement specialist, Retirement Advantage, has recently launched a lifetime mortgage range for buy-to-let investors. Its products allow you to choose to pay off the full amount at the end of the loan, pay whole or partial interest, or pay off up to 10% per year without an early repayment charge. There is also the option of adding a cash reserve to withdraw more equity in the future.
It’s a flexible financing arrangement, which allows you to keep your portfolio intact without having to sell properties to raise cash.
Advantages for retirees of using a lifetime mortgage on investment property
If you have a property portfolio on which there is a significant amount of equity available, taking that investment now by borrowing via a lifetime mortgage has a range of advantages. The strategy:
- Enables you to keep your portfolio intact
- Allows you to continue to benefit from the income on all your properties
- Avoids capital gains tax, because you are not selling any property
- Allows money to be released tax-free
- Will reduce inheritance tax, because the amount owed will be deducted from the value of your estate
Are there any disadvantages of using a lifetime mortgage to release cash from a property portfolio?
The answer, of course, is yes. Most obvious is the potential amount of loan that your beneficiaries might have to repay. If you pay less than the full amount of interest, the loan amount rolls up with the unpaid interest. Over several years, a sizeable underpayment of interest could potentially leave your beneficiaries owing more than the value of your property portfolio. It will be the case if property prices rise by less than the unpaid interest: an unlikely scenario, but a possibility, nonetheless.
However, there is another disadvantage of lifetime loans on a buy-to-let property if you then decide to sell the property before death. You must be aware of this before you take a lifetime loan on investment property.
Beware the capital gains trap on investment property and lifetime mortgages
When considering tax, both your main residence and an investment portfolio is counted as part of your estate for the calculation of inheritance tax. However, they are treated differently for capital gains tax purposes. The main residence is not liable for capital gains tax, whereas an investment property is.
Capital gains tax is calculated on the difference between the sale price and the original purchase price. You don’t deduct the outstanding mortgage from the sale proceeds. You will pay either 18% or 28% in capital gains tax (depending on whether you are a basic rate or higher rate taxpayer respectively) on the gain made.
Let’s say you buy an investment property for £150,000, with interest only mortgage of £120,000. You sell the property for £250,000. At the time of the sale, you were a higher rate taxpayer. You will need to pay £28,000 in capital gains tax (assuming you have used your capital gains tax allowance already). You will also have to repay the £120,000 mortgage, leaving you to cash in hand of £92,000 from the sale.
Now let’s look at an example where you have taken a lifetime mortgage to repay the original loan and release equity:
You bought the property for £150,000, with interest only mortgage of £120,000. You take a lifetime mortgage of £200,000. You pay partial interest for four years (3% instead of 6%), and then decide to sell the property because it has started to underperform. You are offered £250,000. But:
- The partial payment of interest means that the outstanding loan is now £226,000
- The capital gains tax is £28,000
- The amount you must pay in total is £254,000
You must shell out £4,000 to sell your property! (And this is before estate agent fees, legal fees, etc.)
The new lifetime mortgage for property investors is a useful addition to the mortgage and financing product range. For some, it could provide a useful boost to finances in retirement. However, the treatment of investment property for capital gains tax purposes could be a red card. It is especially true if you are a higher rate taxpayer and don’t repay at least the full amount of interest on the loan.
If you are considering a lifetime mortgage on your property portfolio, our advice is to consult with your accountant and financial advisor first. A tax-free lump sum is tempting, but tax liability is only deferred and not deleted. Instead of giving you extra financial power, a lifetime mortgage could paint you into a corner where there is no exit door available.
If you’re a retiree and seeking to maximise your finances in retirement by property investment, contact one of the Gladfish team today on +44 207 923 6100. We’ll help you create a property investment strategy to help you achieve your lifestyle goals and retirement plans – and we’ll show you how to avoid the remortgaging tax trap.
Live with passion,