“Waoo, no tax to pay, that’s amazing! Thanks a lot for wonderful news”
This kind of reaction I usually get when my clients ask advice for their property investment.
This is a fairly a common situation, you bought a property some years ago, and which value has risen significantly since then. You can realise the ‘profit’ from this growth by re-mortgaging or obtain the cash value of your equity by different means, rather than sell the property.
However, whilst this might initially seem to be a very good way of avoiding tax on the growth in the capital value of your investment properties, there are some long term dangers inherent in this strategy which could ultimately prove to be your downfall if you are not prepared for them.
The disparity between initial tax-savings benefits of re-mortgaging and the likely consequence of the strategy is what make me to call this scenario ‘Unseen Trap’. Initial apparent benefit make it unseen to a costly trap from which it is difficult to escape.
I will talk more about the trap later. Let’s look at the short terms benefits of the re-mortgaging approach.
In the short term, this plan works extremely well from a tax point of view. Theoretically, realising equity value through re-mortgaging can produce benefits under each of the three main taxes which affect property investors – Capital Gains Tax, Income Tax and Inheritance Tax. To clarify these benefits, let’s look at a good example.
Illustration : Part 1
Indranee has a buy-to-let property in Broxbourne which has increased significantly in value since she bought it for £25,000 in November 2002. In fact, the property’s current market value is £95,000.
However, Indranee feels that property values in Broxbourne are unlikely to increase significantly in the near future and now she would like to invest in some new developments in Kent. In order to take up her new investment opportunity in Kent, Indranee will need to ‘cash in’ her equity in her Broxbourne property. Initially she considers selling the Broxbourne property, but she is horrified to learn that she would have a Capital Gains Tax bill of £19,600. (She is in higher rate tax band, She has already utilised her annual exemption elsewhere.) After repaying her original mortgage of £30,000, Indranee would be left with only £45,400 to invest in Kent.
Instead of selling the Broxbourne property, therefore, Indranee decides to re-mortgage it. Her new mortgage is at 85% of current value, £80,750. Hence, after repaying her original mortgage, Indranee has freed up £50,750 of equity value in cash. She therefore has an additional £5,350 (or 11.8%) more cash available for her new investment than she would have done if she had sold the Broxbourne property. And, what’s more, she still has the rental income from her original property.
Benefit one: Capital Gains Tax
Capital Gains Tax can normally charge where there is a disposal of an asset. If you sell a property, you have made a disposal and hence, usually, there will be Capital Gains Tax to pay.
On the other hand, however, when you re-mortgage a property, you have not actually made any disposal, as you still own the property. Therefore, although you will have realised some of your capital, you cannot be charged any Capital Gains Tax.
Although, in our example, Indranee did this for investment purposes, this Capital Gains Tax benefit remains equally true whatever your reason for re-mortgaging a property.
Illustration : Part 2
Indranee uses the £50,750 which he generated by re-mortgaging her Broxbourne property as a deposit on a buy-to-let development in Kent. However, when she is completing her next Tax Return, Indranee is uncertain what to do about the mortgage interest she is now paying on the Broxbourne property. Fortunately, her brother Zahir (a Chartered Accountant) is able to point her in the right direction.
Zahir explains that the portion of the interest which relates to the original £30,000 loan (i.e. 30,000/80,750ths or 37.2%) should continue to be claimed against the rental income from the Broxbourne property and the remainder (50,750/80,750ths or 62.8%) can be claimed against rental income from the Kent properties.
“In fact”, Zahir explains, “you could even have claimed the interest on the new part of the borrowings if you had re-mortgaged your own home instead because it’s where you spend the money that matters, not where it came from.”
Benefit two: Income Tax
Where the funds generated by re-mortgaging an existing property are used to purchase new investment properties, the interest on the new borrowings can be claimed against the income from the new properties. This remains true even if the re-mortgaged property itself is the borrower’s own home. The interest relief remains available as long as the funds are invested for business purposes.
Sometimes, however, the borrower will re-mortgage a property for other reasons – perhaps simply to provide living expenses. Whilst this will still produce the Capital Gains Tax benefit described above, there will be no Income Tax relief for the interest on the new borrowings in this instance.
Illustration : Part 3
For the next ten years, Indranee continues to re-mortgage her existing properties and invest her realised capital growth in new buy-to-let developments. By September 2014, she has 12 properties in Broxbourne, Kent and Birmingham worth a total of £3,000,000. Her borrowings at this stage amount to £1,600,000 in total, giving her a total net equity value in her property portfolio of £1,400,000.
Indranee went to visit her brother Zahir, who she hasn’t seen in years, and tells him how well her property portfolio has grown. “That’s great”, says Zahir, “have you done anything about the Inheritance Tax though?”
Once again, Indranee is shocked to discover that she has a huge potential tax bill on her properties – this time Inheritance Tax of £560,000. “Well, I’m wealthy enough now”, she thinks, “I’ll stop investing in new properties, live off the existing ones and give as much as I can away to my family.”
For the next ten years, Indranee continues to re-mortgage her properties up to 85% of their market value and she spends or gives away the proceeds. By 2024, her portfolio is worth £5,000,000, but she has total borrowings of £4,250,000, leaving her with a net equity value in her portfolio of only £750,000 and thus reducing her potential Inheritance Tax bill to only £300,000.
Benefit three: Inheritance Tax
Re-mortgaging your properties as much as possible is an effective way to limit the net value of your estate for Inheritance Tax purposes. Rather than selling properties, which creates Capital Gains Tax liabilities, this enables you to give away some of the value of your assets, hopefully tax free (as long as you survive for seven years after making the gift).
Of course, to save Inheritance Tax, you will need to spend or give away the proceeds of re-mortgaging your properties, so this technique does not allow you to claim any Income Tax relief on the new borrowings. Following this method may also put a severe strain on your cashflow. One of the ways to ease this would be to use some of the funds realised through re-mortgaging to purchase annuities, thus keeping the value of your estate down for Inheritance Tax purposes, whilst still providing you with an income during your lifetime.
Naturally, you need to be able to afford to spend or give this money away and still be able to pay the interest on your ever-increasing borrowings, so this strategy is not for everyone!
The Unseen Trap
So far, we’ve looked at the ‘Initial Apparent Benefit’ part of the re-mortgaging strategy, namely the potential tax benefits. Now we turn to the unseen trap.
The problem in essence is that Capital Gains Tax is based on the difference between sales proceeds and purchase cost. Hence, in order to calculate the capital gain arising when you sell a property, you deduct the original cost of the property from your sale proceeds. What you do not deduct in your capital gains calculation is the outstanding amount of the mortgage over the property.
Obviously, if you have used additional borrowings to make improvements to the property, then these costs may also be deducted from sale proceeds. However, where your additional borrowings have been spent, given away or used to invest in other properties, you will have a liability to the lender without a corresponding deduction in your capital gains calculation. This is what creates the trap and we will go back to Indranee’s brother Zahir to see it in action.
Illustration : Part 4
In 2025, Indranee runs into some financial difficulties and decides that she needs to sell one of her properties. The rental yield of his original Broxbourne property has been pretty poor lately, so she sells this property for £380,000. Her borrowings against this property now amount to £316,000, so she realises net proceeds of only £64,000 (even before any sale expenses).
However, as Indranee’s original cost for the property was only £25,000, she realises a capital gain of £355,000. As he’s held the property for over ten years, she is entitled to taper relief of 40%, reducing her gain to £213,000. Nevertheless, as a higher rate taxpayer, she is still left with a Capital Gains Tax bill of £85,200. (Once again, she has used up her annual exemption elsewhere.)
After tax, Indranee’s sale of the Broxbourne property has actually generated an overall net cost of £21,200!
In fact, if Indranee were to sell her entire £5,000,000 portfolio, she would need to find an extra £104,000 to pay her tax bill!
Preventing The Unseen Trap
Indranee’s story is a lesson to us all. It’s only an example, I know, but I have met property investors who are in a very similar position, or who will be if they keep on the way they’re going.
Avoiding the trap is possible, but does require some drastic action. The first option is to hang on to the properties until you die. This resolves the Capital Gains Tax problem and, as we have seen, the level of borrowings keeps the Inheritance Tax bill down.
If Indranee had died before selling her properties, the portfolio would have yielded a net sum of £450,000 for her family after Inheritance Tax, rather than creating an overall cost of £104,000. This is because Capital Gains Tax is not charged on death. Furthermore, for future Capital Gains Tax purposes, the decedent’s beneficiaries are treated as having acquired the properties at their market value at the time of death.
This is all very well, but what if you can’t afford to keep the properties. This could happen for a variety of reasons, rental yields could fall, interest rates could rise. Additionally, as you get older, you may need to employ more help to maintain the portfolio and this will impact on your overall cashflow.
On the other hand, though, if you have insufficient other wealth beyond your property portfolio, you may be unable to fund the Capital Gains Tax bill arising if you do sell! You could end up not being able to afford to keep the properties, nor able to afford to sell them!
In a case like Indranee’s, I would probably recommend emigration as her best chance to avoid the unseen trap. If she went abroad before selling the properties and then stayed away for at least five whole tax years, she would be exempt from UK Capital Gains Tax. Still quite drastic, but not as bad as the previous option.
it is advisable to avoid getting into Indranee’s type of situation in the first place. To do this, the re-mortgaging strategy should be limited to a ‘prudent’ level.
For properties held for less than three years, the ‘prudent’ for your borrowing is ‘original cost plus 60% of any increase in value’. On each anniversary of the property’s purchase from the third anniversary to the tenth anniversary, the percentage of ‘increase in value’ which may safely be borrowed goes up by two percentage points. Eventually, for properties held for ten years or more, the ‘prudent’ borrowing becomes ‘original cost plus 76% of any increase in value’.
Keeping mortgage levels down to these ‘prudent’ borrowing levels should ensure that you will have sufficient net funds arising on a sale of the property to be able to pay your Capital Gains Tax bill. To err on the side of caution, though, I would also advocate reducing the resultant ‘prudent’ figure by a further 5% to safeguard against a downturn in property values or any other unpleasant surprises.
Using a re-mortgaging strategy to build your property portfolio has tremendous potential Capital Gains Tax and Income Tax benefits. Realising your equity through additional borrowings is more tax efficient than selling properties when you intend to reinvest the proceeds in your portfolio.
Re-mortgaging can also be used as a method to keep the value of your net estate for Inheritance Tax purposes down to a reasonable level. However, an unseen trap awaits the unwary and can, in the most extreme cases, put the taxpayer in a quite untenable position. Sticking to ‘prudent’ levels of borrowing should ensure that you don’t fall into this trap.