EIS CGT Deferral – Tackling the ‘terrible tax change’ on buy-to-let

Landlords who directly own mortgaged buy-to-let residential property are facing a seismic change to their financial position as they cease to be able to run the arbitrage between rental income and cheap debt.

As of April 6th 2017 interest payments will gradually cease to be an allowable deduction against rental income, turning historically profitable portfolios into cash negative assets.

So serious is this adjustment by the Government that former Bank of England economist David Miles referred to it as ‘terrible’. 

You can find HMRC illustrative case studies of the changes here.

So what does this mean for historic property owners who have relied on real estate to provide both wealth and income?

  1. As they sell out of the residential property asset class they will see a 28% Capital Gains Tax (CGT) levied – a significant impact on their net worth.
  2. They need to find a new means of wealth generation; no easy task at a time of such low interest rates.

One investment tool that suitably addresses this change in circumstance is EIS.  It allows for CGT deferral so as to keep investor net worth undiminished,  Income Tax relief to bring down the net cost of investment, and Share Loss Relief to reduce exposure to company failures.   In addition any capital gains are free of tax, and EIS shareholdings are exempt from inheritance tax after two years ownership – all assisting in the maintenance and creation of wealth.  For the right client with the right circumstances these advantages can all aggregate within one subscription.

EIS investment reliefs were created by the Government to encourage innovation in the UK and create jobs in the private sector.  EIS Growth Funds are focused on investing in qualifying companies with significant growth potential.  These companies have to be early stage and unlisted (with the exception of AIM) – so by default this is classified as an ‘illiquid and high risk’ asset class.  While this statement holds true of the underlying companies themselves, the layer of expertise added by successful EIS fund managers and the downside protection provided by the tax reliefs creates a material advantage to the investor, offering a real opportunity for wealth generation.

Taking the case of a buy-to-let individual now investing in EIS, using only the gain realised from residential property sales, the below example shows how CGT deferral allows for future settlement of the tax liability using a combination of reliefs and portfolio profits.

Assuming the property sale creates a gain of £100,000, on deployment of the capital the investor receives £30,000 Income Tax Relief – enough on its own to settle his/her CGT liability which at 28% would be £28,000.

The example shows a portfolio performance of 2x multiple return providing a net exit, including settlement of the deferred CGT, of £231,450 on £100,000 invested.  This does not include any future benefit of IHT exemption at 40%.  Even if the portfolio performance was lacklustre and near flat, the argument would still be extremely compelling due to the tax reliefs where on investment the combination of Income Tax Relief and CGT deferral immediately provides a 58% tax advantage over investing in say FTSE 100 stocks.  That’s a huge hurdle against which to benchmark the expected performance of other asset classes.

Summary

No one would suggest EIS as an equally weighted alternative asset class to property.  That said, in that first transition out of a buy-to-let portfolio the portion of sales revenue that is capital gain is highly unlikely to find a more attractive investment than EIS.

EIS should represent a small part of an individual’s overall portfolio, however returns can outperform much larger positions in other asset classes – which is a sensible way to think about EIS allocation – higher risk for higher rewards – with a substantial downside protection buffer provided by HMRC, and an added incentive for those coming out of buy-to-let property.

 

(this article first appeared on www.propertyreporter.co.uk)

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