Q: Is commercial property unaffected by mortgage tax relief reforms and how different is it from residential?
Now that mortgage tax relief reforms have been phased out, residential landlords have seen the percentage of finance costs that are deductible from rental income drop from 75% to 0% as a basic rate tax reduction of 20% was introduced in 2020. HMRC realised that UK-resident landlords who let residential properties in the UK or overseas, who live overseas and let properties in the UK, or who let residential properties in partnership or trust would be affected; but it also calculated that only some landlords would end up paying more tax. This remains an important point that we’ll come back to later.
Commercial property, residential property owned by a UK-resident company or non-UK resident company and furnished holiday lettings are all unaffected by the mortgage tax relief reforms. Commercial property is any that is used for running a business such as a hotel, offices, a shop, a shopping mall, industrial units etc. Many landlords have been tempted by commercial property for this reason and because it avoids the additional 3% stamp duty for second properties.
There is even the option of semi-commercial investments for those residential landlords who want to find their feet first. Semi-commercial properties are those with a mixed use, a flat above a shop for example; properties such as this avoid the 3% stamp duty and the mortgage tax relief reforms, on the shop part at least, and they generate two sources of income. All commercial properties typically have higher rents (so higher rental yields) but that’s because they have higher risks too.
Understand the risks
Commercial properties not only rely on a tenant paying each month but that their business is profitable in order to do so. Even on a small scale, this is still more of a concern than a buy-to-let property as it is important to understand the tenant’s business rather than simply checking their credit history.
Mortgage lenders too, assess the affordability of a commercial property based on the tenants’ business rather than the landlord’s ability to repay the loan. They will take into account expected rental income as well as the business’ success, for this reason vacant possessions will have trouble securing a mortgage. The type of business will also be a deciding factor – pubs, restaurants and bars tend not to have longevity so lenders will be likely to shy away from them. It is wise to have a stable and profitable business already in place before you buy.
Commercial landlords are limited to specialist commercial mortgages and if you have no experience with commercial property then few lenders will consider your application. You could partner with someone with experience to allay their fears or you could consider peer-to-peer or crowdfunding as finance options though these are complex and could tie up your investment.
Finally, mortgage rates will be higher and linked to the tenant’s lease so many lenders will expect the lease to match the length of the mortgage as well as wanting to see evidence that the landlord can meet expected costs.
If commercial is starting to sound like an unlikely option, consider the HMRC’s assertion that only some landlords have paid more under the new system.
Spot the difference
Property Geek did a simple scenario to show that landlords may have been worrying unnecessarily. Under the pre-2020 system mortgage interest with all costs could be deducted from profit before working out the tax, so a £10k rental income with a £5k mortgage interest cost and £1k associated costs would net £4k profit that would be taxed, at basic rate (20%) £800, or at higher rate (40%) £1,600.
Under the new system, mortgage interest cannot be deducted so the example above becomes a £9k profit which would incur £1,800 tax at basic rate and £3,600 at higher rate. But then, as everyone can now claim a basic rate (20%) tax deduction from the profits, the basic rate tax payer in the example can deduct £1k from the tax bill (20% of £5k is £1k) to pay £800 in tax which is the same amount as before. While the higher rate tax payer suffers paying £1k more than before. Property Geek’s example shows that superficially, residential landlords on a lower tax rate have experienced no real change, however, as the tax is worked out on a profit basis, income from other sources could lift basic rate tax payers into the higher band (of a £50k threshold by 2020).
If this looks likely, you could always convert to a company (with the associated capital gains tax and other liabilities), sell unprofitable residential properties or consider trying the commercial side. While commercial properties are more complex to run and challenging to find mortgages for, they do offer higher rental yields, are unaffected by the mortgage tax relief changes and have more security with long-term leases and annual rent increases linked to inflation.
Tax issues aside, there are several key points that prospective investors might want to clarify before making a decision concerning the commercial vs residential question.
Q. Is there a difference in how the respective mortgages are processed?
A. The main difference is in the timescales involved. When buying a commercial property, your bank will ask for more documents which will take more time to process. It is important for buyers to factor this in their plans because getting the data finalised for consideration may take weeks rather than days.
Q. Why are deposits for a commercial property so high in comparison?
A. How quickly a property can be disposed of in a forced sale situation is one of the key concerns of a commercial property lender. Because of this extra risk, the loan to value (LTV) for a commercial purchase will be 65-75% of its market value in contrast to the 90% offered to residential buyers. This then requires the buyer of a commercial property to put up a much bigger deposit.
Q. Are there any chains to consider when buying commercial?
A. The multiple parties in a residential property chain means there is a greater chance the purchase will fall through. Commercial deals are typically chain-free which makes the process a whole lot smoother and avoids many of the delays and risks that can derail a residential deal.
Q. How does the length of occupation influence the respective transactions?
A. Residential buyers nearly always prefer long term arrangements and expect to negotiate a freehold, or long (e.g., 99 year) lease of their homes. Making a long-term investment in a commercial site may prove to be an unwise move if the business is unproven. Shorter terms of 10 years are the norm.
Q. How do the stamp duty (SDLT) rates for commercial/mixed use premises differ from the rates for residential premises?
A. The start point for tax on residential properties is £125,000 whereas the starting point for tax to be payable on commercial sites is £150,000. There are also different rates of tax payable (the highest is only 5% on commercial properties but can be as high as 15% on residential properties in certain circumstances). There are also more SDLT reliefs for commercial transactions compared to residential ones.
Q. Is there a difference in tenancy renewal procedures?
A. Most buy to let investors will know that their tenants (as the law currently stands), Residential tenants have limited security of tenure and once the agreed lease period expires the landlord can give two months’ notice in order to get the premises back. The opposite applies in the case of commercial properties. A commercial tenant has a statutory right to renew their lease when it ends unless the parties have previously agreed otherwise. Landlords who want the premises back to let to someone else at a higher rent may find that the law is not in their favour.
It is quite clear then, that anyone attracted to the potential higher yields offered by commercial properties needs to take a long, hard look at their attitude to risk and appetite for extra paperwork. However, if you are a residential landlord at heart and would like advice on how our services can make your properties more profitable or how we can help you to achieve high rental returns then don’t hesitate to get in contact with the team.