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The Buy To Let Trap

My portfolio contains 3 buy to let properties that are rented out. Each property has a mortgage on it which over the years I have paid down to some extent. However I have been facing the time honored buy to let issue: when should I pay down the mortgages on my buy to let properties?

The Buy to Let Mortgage Trap

The ‘problem’ is that I am currently a higher rate (40%) tax payer. My financial/retirement plan dictates that at some point in the future the day job will be shelved (or maybe it’ll shelve me) and I’ll be living off the fruits of the money tree. As a result I have two main financial priorities:

  1. Minimise my current income tax bill
  2. Maximise my investments that will provide future income

In order to minimise my income tax liability I aim to not make a monthly profit on my buy to let properties.  If the rental income exceeds the allowable expenses (mortgage interest, repairs and legal fees being the main ones) I have a tax liability on this amount. In other words I pay 40% tax on any income related profit the properties make.

As a result I am incentivised not to overpay the mortgages too much and to leave them at a state where the monthly mortgage interest (which is a tax deductible expense) is roughly equal to the rental income.

I will only pay off the mortgages only when I need the income they produce. The Buy to Let trap I am currently in is how and when to pay them off. Lets have a look at my options:

1. Use My Current Income

As described above, any increase in my net income as exposes me to a 40% tax liability. Therefore on the face of it it makes sense to keep the mortgage high and invest the money I would have used to reduce the capital elsewhere.

2. Save the capital in an ISA

The obvious answer to the problem would be to use ISA accounts (and their tax free benefits) to save the capital to repay the mortgage at a future date. At some point in the future (when I need the income the properties produce) I can use these ISA savings (and any gains they’ve made) to pay off the mortgage debt.

The big problem I have with this option is that I want my cake and to eat it too. The tax free income my ISAs produce is not something I want to give away. That tax free income is a big part of my retirement plan and a core foundation of the money tree.  I want to do everything I can to keep the capital invested in the ISAs and maximise my future tax free income.

3. Save Outside of ISA

At the time of writing I could tuck away some cash (ear marked for the mortgages) in a 5 year fixed rate savings bond that would yield 3.25%. The only problem is that [for any investment] outside a tax wrapper, this yield drops down to 1.95% once I factor in my tax rate. This net yield then is less than the cost average APR of the outstanding mortgages (not to mention inflation) so again I’d be throwing money away.

4. Use My Pension

The only solution that seems to tick all of the boxes is to make any savings earmarked for mortgage repayments into my pension pot. I can then use the 25% tax free lump that I’ll be able to take out of my pension upon retirement to pay down the loans.

By using this approach any ‘savings’ I make and mentally allocate towards paying off the buy to let loans are sheltered from tax. In addition I’ll benefit form the tax relief on pension contributions and the relative freedom to invest these ‘savings’ as I see fit.

The Risks

Of course, as with any financial strategy, there are risks. I need to carefully consider the following points:

  • When I retire I may not be able to rush out and buy a sports car!
  • Will 25% of my pension pot at retirement will be enough to pay off the outstanding balances?
  • Will income draw down on 75% of my projected pension pot provide me with enough income in retirement?
  • If interest rates rocket back up (unlikely as it may seem in the short term) my ability to pay off capital will be locked up in a pension fund where I won’t be able to access it until retirement.
  • Are the loans due to be repaid before I retire?

I’m quite heavily exposed to property in my portfolio with 3 buy to lets. I can’t see how/why the demand to rent properties in this country is ever going to fall significantly (limited supply + increasing population) so the future income they produce appears to be safe.

My strategy is a buy and hold one so their values (and property prices in general) aren’t really a concern to me. The biggest risk I am therefore running on this part of my portfolio with this strategy is the interest rate risk. This risk is partly hedged by my cash holdings and for the time being at least I’m willing to run the remainder of this risk…..

{ 9 comments… add one }
  • Monevator January 25, 2014, 9:46 am

    I’m not a pensions alarmist, but there has to be a risk the 25% tax free lump sum will be curtailed at some point. You’d hope it would not be retrospectively applied, but…

    I haven’t looked for years, but are there any decent Zero Income preference shares around these days? They used to be handy for this sort of situation.

    Another option — risky but potentially rewarding — would be to buy another 1/2 properties and sell those in (say) 15-20 years to pay off the mortgages of the others?

    In any event, you have a “high class problem” here. 😉

  • Early Retirement Canada January 26, 2014, 8:26 pm

    How about invest the money outside your ISA? If you go for a non-distributing ETF, you’ll only pay cap. gains when you sell.. right?

    • Under The Money Tree January 29, 2014, 2:37 pm

      ERC – Actually that is a great idea and one I hadn’t thought about to be honest. Like you say i’d only be paying capital gains plus any fees charged. Probably better than a distributing fund + income tax. I’ll have to run the numbers…..

      • Under The Money Tree February 24, 2014, 4:39 pm

        Just a follow up on this idea. Accumulation units (granted by accumulation funds) are liable for income tax 🙁

  • BeatTheSeasons February 4, 2014, 3:19 pm

    A couple of questions immediately spring to mind:

    1. Why are you a higher rate taxpayer? Even if you can’t turn yourself into a limited company you can still avoid all the 40% tax by paying into a SIPP. Surely you should be doing this anyway, not just because of the BTL trap.

    2. What about your wife – is she a higher rate taxpayer? If the properties are in your name you could transfer them to her, or at least hold them 50:50. As you are married there will be no CGT liability in doing this, although there could be stamp duty depending on the size of the mortgage. If you have children you’ll also find this a useful way to avoid wasting her personal allowance and 20% band while she’s on maternity leave as she could receive the rental income.

    • Under The Money Tree February 4, 2014, 4:11 pm

      1. As you suggested turning myself into a limited company isn’t an option for me. Neither I’m afraid is paying all of my income over the 40% threshold into a SIPP. I take a balanced approached so any spre income is roughy split evenly between ISAs, SIPPs and [residential] mortgage over payments. The main reason is I plan to semi retire quite a few years before I’m able to draw down any pensions.

      2. We’re both currently higher rate tax payers. In fact one of the properties is in her name so we both have the same issue!

  • BeatTheSeasons February 4, 2014, 5:26 pm

    If I was in your position I would be looking for a decent accountant to come up with some long-term tax avoidance schemes. They can help you plan ahead so you don’t find yourself blogging about another ‘trap’ in a few years time!

    Other than that, the only suggestion I would have is to remortgage one of the BTL properties to release a tax free slug of cash and use that as your spending money and ISA deposit. Then you’ll have more of your salaries left over to pay into your SIPPs so you can avoid more 40% tax. If your employer has a salary sacrifice scheme you can potentially save up to 15.8% national insurance as well.

  • Peter Driver January 19, 2017, 6:36 pm

    I am owner of 3 rental properties. 2 with mortgages one paid. I need income to be registered for Home Office spousal visa qualification over 5 years. I am british. Wife non. I am 64. Is this a good pension alternative as I have no pension in Uk. Your thoughts. Thanks

    • Under The Money Tree January 21, 2017, 12:53 pm

      Peter,

      Well that all depends. How much is left to pay from the mortgages, how much income do they produce, what are your income requirements in retirement. How long is a piece of string?! It sounds like you’re in a good position though (depending on your leverage).Do you have any other income producing assets outside of property?

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