Last week I wrote about savings rates and how I calculate them. This week I want to expand on that and show you how I factor in my house and my mortgage. Again I’m not saying this is the only right way to do it, but it makes logical sense to me and I wanted to share, so here you go.
Imputed Rent – The Biggest Tax Break in the UK?
Imagine two people – Adam lives in Oxford and Emma lives in Cambridge and they both own their own homes, which happen to be almost identical in size and value. Now suppose Adam needs to go and work in Cambridge for 12 months, and Emma needs to go and work in Oxford for 12 months. Neither of them want to sell their houses and so they decide to rent them out and, as luck would have it, they end up renting from each other. They both pay each other the same rent, let’s say £1k a month.
You might think this is an ideal scenario, both Adam and Emma maintain the same standard of living and neither are out of pocket. However, they are both now earning £12k a year in rent, and that is taxable income. 20% of that must be paid to the government, and it could be 40% or 45% if they are higher earners.
Now, it might seem strange to think about it this way, but all owner occupiers are actually doing this, all of the time. They are effectively renting to and from themselves. Their house is an asset that allows them to live rent-free. In theory at least, that asset is producing a form of income from which they are benefiting.
According to the New Economics Foundation:
“Inclusion of how much home-owners would pay if they actually rented boosted UK GDP in 2014 by £158bn – an 8.9% share.”
Income is taxed of course, but a UK politician would be mad to try and implement a tax on imputed rent. It would be electoral suicide, especially when you consider that over 60% of the UK population is an owner occupier.
Still, IMHO a tax on imputed rent is not a bad idea. It would be a powerful redistributive tax and could replace the regressive council tax we currently have in place. And it’s not completely beyond the realms of possibility either. Iceland, the Netherlands, Luxembourg, Switzerland, and Slovenia all have some form of tax on imputed rent. Perhaps in the future, if the trend towards renting in the UK continues we might see growing calls for it. A politician might come along and argue for a reduction in tax on labour that could be financed by a tax on imputed rent.
Side note: Imagine what the imputed rent on the Queen’s abode Buckingham Palace might be? Apparently it’s worth about £5bn, so if you assume an imputed rent of 5% of that value then that would be about £4.8m a week. Tax that at 40% and the Queen would owe the taxman about £100m a year. Seems fair to me!
Anyway, that’s all by the by. What was supposed to be an intro to this post has turned into a bit of a political ramble, so I will move on.
Imputed Rent and Savings Rates
I believe it’s important to factor in your imputed rent when working out your savings rate. Why? Because your house is an asset which means you don’t have to pay rent. ‘But I’m paying a mortgage,’ I hear you say, ‘surely that is basically the same thing as paying rent?’ Well, not really, because you own a percentage of your house, and eventually you will have paid off your mortgage, assuming it’s a repayment mortgage, and so eventually you won’t have to pay rent at all.
(I suppose if you were paying an interest-only mortgage then you might consider that similar to rent. But it is only rent on the proportion of the house that you don’t own. If your house is worth £200k and your mortgage is £120k and you have an interest-only mortgage then yes, you are paying rent to the bank for that percentage of your house, in this case 60%. But you own 40% of the property for which you’re paying yourself rent, ie an imputed rent.)
A Real Life Demonstration
I will demonstrate using firstly my rental property, and secondly the house I live in.
My rental property is an HMO (house of multiple occupancy) and I have 5 tenants:
- Rent = £1800/month
- Mortgage Interest = £240/month
- Mortgage Repayment = £360/month
- Bills = £500/month (I pay for the utilities, council tax, cleaners, etc)
In the eyes of the taxman my rental property is giving me about £1060 a month in income (let’s ignore all the tax changes of recent years for now). That is, my revenue which is £1800, minus my costs which are £740 (£500 bills + £240 interest). The £360 repayment is to some extent irrelevant – it is a saving really because I’m paying down my debt and increasing my equity.
Now I do the same thing for the house I’m living in.
- Rent (from 2 lodgers) = £800/month
- Imputed Rent (for my room) = £550/month
- Mortgage Interest = £450/month
- Mortgage Repayment = £450/month
- Bills = £350/month
The mortgage is quite a bit higher for the house I live in as the loan-to-value is higher (about 75% vs 40% if you’re interested). So what is my income from the property? Using the same calculation as before, it is revenue (£1350, ie total rent) minus costs (£800, ie mortgage interest and bills), which is about £550 a month.
So between my two houses, a normal month would net me about £1610 in passive income. Of course there are other costs as well, buildings insurance, repairs, maintenance, furniture/appliance replacement and so on. And then of course there’s the biggie: tax, which when working out your passive income you’ll need to take that off. Looking at my spreadsheet over the last 12 months (Aug 17 – Jul 18) I work out my passive income from the two properties was just over £13k, or £1.1k a month.
That probably sounds great but bear in mind I’m also paying £550 a month in rent. I’m paying it to myself of course, and I don’t actually move any money around, but according to my spreadsheet that is an expense each month that must be paid for, and that should be factored into my savings rate.
For a lot of rental properties the tenant will pay the bills so you might work out things a little differently. Likewise, if you are the only person living in your house (when I say ‘you’ I mean ‘you and your family’) then you might decide to put the bills down as an expense rather than increasing your rent and taking the bills off that. It doesn’t make a difference, mainly because of how I work out my savings rate, which leads me nicely onto…
Savings Rates and Your Mortgage
You might remember in my last blog post I mentioned a new formula for working out your savings rate:
Old formula: Savings Rate = 1 – (Expenses/Income)
New formula: Savings Rate = 1 – ((Expenses – Passive Income)/Active Income)
Let’s say in a standard month my active income is £3400 and my passive income is £1100. And let’s say I spent £2k. Bear in mind that £2k includes my £550 imputed rent, but it doesn’t include things like bills or my mortgage because those are already factored into my passive income. What is my savings rate?
Old formula: Savings Rate = 1 – (2000/(3400+1100)) = 0.56, or 56%
New formula: Savings Rate = 1 – ((2000-1100)/3400) = 074, or 74%
That’s a big difference there. With a 56% savings rate it will take me just over 13 years to reach Technical FI, with a 74% savings rate it will only take 7.5 years. As I explained in my previous post I do believe the new formula is the correct way to work out your savings rate.
Note that (in theory) using the new formula means it doesn’t make a difference to the savings rate who pays the bills for utilities (tenant or landlord). If the tenant pays then that means passive income and expenditure should both be lower for the landlord, so the equation isn’t affected. For example with my rental property if my tenants paid the bills themselves and I received less rent from them because of that, then my passive income would stay the same. Or if I take my own property and put my bills down as an expense and reduced my rent by £350/month then my passive income would be lower but then so would my expenses. Using the new formula the savings rate will be unchanged.
How do you work out what your imputed rent should be?
There are few ways to do this.
- I don’t recommend this approach as it’s a bit immoral, but you could call out a letting agent, tell them you plan to rent your house out, and ask them how much they think you could rent it out for.
- Look on RightMove or a similar website for properties that are being rented out near you. Ideally find a property that is the same size in the same sort of condition. This isn’t going to be possible for everyone but for most people you can get a rough idea using this method. I know for example that there is a house a few doors down from mine that is almost identical and is advertised at £1100/month, to be let out as a whole, unfurnished, bills to be paid by the tenant.
- Take the value of your house and multiply it by 0.05, that is, 5%. Most landlords when they’re looking to buy a new property will be looking to achieve this sort of yield. Bear in mind that is to let out a property as above; as one unit, unfurnished, bills paid by tenant, so if you’re factoring in bills then increase the rent by that much. If you’re not sure the value of your property you could try Zoopla or Mouseprice that will give you an estimate, but also look at similar houses currently for sale, and recent sales as well.
- Erm… I don’t know any other ways of working out imputed rent.
I believe in countries that tax imputed rent the third method is used. Presumably surveyors must be in high demand there to work out house values, and there must be some sort of disputes process in case of overvalued houses. I must admit I don’t know the details there.
For a little while I wrestled with all this thinking it can’t be right, because then it would be sound advice to buy as big a house as possible to maximise your passive income, and as we all know (in FI circles) buying a big house is a bad idea.
So let’s do another example. Take two families, the Smiths and the Jones’s. The Smiths have bought a reasonable size property in the Midlands for £300k and are mortgage free (that’ll buy you a 4 bed detached house in Northampton, just saying). Let’s say the Smiths also have £400k invested in index trackers giving them roughly a 5% dividend (£20k of income) each year after tax. They are pretty comfortable and have decided they are financially independent.
Now take the Jones’s who have splashed out £500k on a house which they also have finished paying the mortgage for. They have £200k invested in index trackers realising about £10k of income each year. They have decided they are not financially independent because they don’t think £10k a year is enough to get by on.
Both families have the same net worth of about £700k but one is financially independent and the other isn’t. It seems obvious why, but if you were to take the savings rates calculations above and assume a 5% imputed rent and say, £18k expenditure (food, bills, holidays etc) each year, and perhaps a £30k salary from their jobs this is what you’d get:
- Active Income = Salary = £30k
- Passive Income = Imputed Rent (15k) + Dividends (20k) = £35k
- Expenditure = Imputed Rent (15k) + Expenditure (food, bills, holidays etc, 18k) = £33k
Savings Rate (Old Formula) = 1 – (33/(35+30)) = 0.49, or 49%
Savings Rate (New Formula) = 1 – ((33-35)/30) = 1.07, or 107%
- Active Income = Salary = £30k
- Passive Income = Imputed Rent (25k) + Dividends (10k) = £35k
- Expenditure = Imputed Rent (25k) + Expenditure (food, bills, holidays etc, 18k) = £43k
Savings Rate (Old Formula) = 1 – (43/(35+30)) = 0.34, or 34%
Savings Rate (New Formula) = 1 – ((43-35)/30) = 0.73, or 73%
As you can see, using the new formula The Smiths have a savings rate over 100% and are therefore FI (technically at least, they might want to save a bit more to be sure). The Jones’s savings rate is good at 73% but they still have a few years of saving before they’ll be able to give up their day jobs. Or course, I wouldn’t be surprised if the Jones’s ended up spending more each year to maintain their house. Extra rooms equals extra furniture, extra cleaning, and extra decoration. A fancy kitchen requires fancy appliances and furnishings to maintain the look. A bigger garden equals more effort and expense to maintain. And so on.
So there you have it, conclusive proof that owning a less expensive house will allow you to reach FI sooner (assuming all other things are the same). What do you think of my approach? How do you factor your mortgage and house into your savings rate? I’d love to hear.
Thanks for reading,