Too Good to be True? Cash backs, “Below Market Value” and other Buy to Let Financing Arrangements - by James Bailey

The current crash in house prices and the nervousness of the lending institutions has not stopped the market for buy to let properties entirely, and indeed some pundits are saying that now is the time to buy. Certainly, for hard pressed property developers, now seems to be the time to sell, as evidenced by the quantity of unsold properties sitting on new developments and representing “dead” capital for their developers.

It appears that Gordon Brown is going to be leaning on the banks to increase their lending. A year or so ago, the pressure was coming from the banks’ directors and shareholders, as they fought for market share in what was then a property boom.

Whenever there is pressure on a market, there will be mistakes made and unwise decisions taken. This article looks at an aspect of the market for buy to let finance which I (and many other commentators) find very worrying.

The classic model for a loan to buy a property was that the purchaser provided a deposit (traditionally 10%) from his own capital, and the bank or building society made up the difference with a loan. In the case of buy to let property, the deposit was more typically 20% or more.

Many institutions woke up to the fact that there were people out there who wanted to get on the property ladder but couldn’t raise the necessary deposit, and in a climate of rising house prices, it seemed good to offer finance to those without capital of their own. The 100% mortgage had arrived.

Some lenders more recently took this to heroic levels, most notably Northern Rock with mortgages of 125% of the value of the property. We now know what that led to.

Another development was “cash-backs”. These started with the lenders offering you a cash payment as an incentive to borrow from them rather than from the bank next to them in the High Street. The next step was for the vendor – typically, a property developer anxious to speed up his cash flow – to offer cash incentives to those who signed up to buy the newly built properties.

The last to enter this playground were the intermediaries – the advisers who put buyers in touch with sellers or with lenders.

All this was interesting but not dangerous, though the tax treatment of such cash backs can be difficult to pin down. In the case of a person buying his own home, it is generally quite straightforward, though if on a sale the property is not wholly exempt from CGT (perhaps because it has not always been his “main residence”), the question of whether you treat the cash back as reducing the purchase cost remains unclear. In the case of the property developer, the position is also clear – cash backs received or offered are brought into the accounts as trade receipts or trade expenses. For the buy to let investor, the position is even more unclear. For Stamp Duty Land Tax, even the Stamps Office do not know the correct treatment – I asked them for a ruling a year ago and they gave me an evasive answer.

This article, however, is not about the finer points of the tax treatment of cash backs. I am more concerned with the potential problems where “market value” comes into the equation.

In many cases, the vendor of a property is prepared to take a price lower than he might otherwise ask for because he needs to sell quickly – whether because of financial problems, or because he simply wants a quick sale for other reasons.

When a property is first introduced into a letting business, it is HMRC’s view that you can finance it up to its market value and get a deduction for all the interest on that loan. This is not problematic in the case of, for example, someone who decides to move out of their home and let it for the first time. They can remortgage the property and deduct all the interest on the loan against the rent they receive.

I am less sure about the situation where a property is purchased for less than its “market value”, and is immediately remortgaged and introduced into the letting business. It must be remembered that HMRC are always a couple of years or so behind the times on new developments in markets, because, broadly speaking, they only become aware of them when the relevant tax returns are filed. In the case of “below market value” schemes, there is nothing on the face of the tax return to show anything unusual is going on, in any case.

It all turns on what exactly “market value” means. For tax purposes, it is a legal fiction, involving the price that would be paid in the open market, between “a willing buyer and a willing seller” acting at arm’s length.

Whenever a chartered surveyor is asked to value a property, he is required to follow his “red book” which sets out various principles he should apply, but with the best will in the world, all he can do is provide a range of values, because the only way to achieve a precisely accurate value is to actually sell the property and see what you get for it.

Where there is a difference (for whatever commercial reason) between the surveyor’s estimate of the value and the actual price the vendor is willing to accept, there appears to be scope to profit from that difference. There are a variety of strategies being marketed which essentially all involve getting tax relief on the interest on the loan representing that difference. As I have said, HMRC have yet to address this issue, but that is not the case as far as the Council of Mortgage Lenders and the Law Society are concerned. In March of this year, the Law Society issued new guidance to solicitors involved in the conveyancing business, and in June the Council of Mortgage Lenders issued their own guidance with particular reference to sales of new properties.

There are a number of schemes on the market, but they all revolve around a basic structure: the vendor is willing to sell for less than the value a surveyor (whether acting for the buyer or for the lender) would put on the property concerned. The purchaser then borrows on the basis of a purchase of the property at “market value”, and “buys” the property for that price. The vendor then returns all or part of the difference to the buyer.

Put baldly like that the scheme is obviously fraudulent, because the lender has been misled into thinking that he is lending on the basis of the property being bought at its “market value” when in fact the reality is that it is being bought for significantly less than that and the higher price on the documents is a sham because it is only being paid on the basis that the vendor will immediately pay it back to the purchaser.

There are much more sophisticated schemes out there, and some of them may be perfectly legal, but any purchaser thinking of using one should be very cautious. The practice guidelines for solicitors referred to above, and the Council of Mortgage Lenders, quite rightly require disclosure of any cash backs, but their rules go further and also require details of “the sources of funds other than the mortgage for the purchase”, and “the price to be paid and whether any payments have been, or will be made, directly between the seller and the buyer”.

Notice that the guidance refers to payments “directly” between the buyer and the seller. Some of the schemes insert one or more intermediaries so that the payments are not (they say) “directly” between seller and buyer. If this is used as a reason not to disclose the payments, be very wary – the 2006 Fraud Act defines any “false representation” made for gain as fraudulent, and includes in this any representation “express or implied”, which is “untrue or misleading”.

There is nothing wrong with purchases below market value, or with cash backs, provided they are disclosed to the mortgage lender, but be very, very cautious before signing up to anything that relies on being less than fully open with the lender about the arrangements surrounding the deal.

It is really quite similar to the difference between legal tax planning and fraudulent tax evasion. Dennis Healey amusingly defined this as “the thickness of a prison wall”, but a more practical definition is that any tax planning that relies on HM Revenue and Customs not knowing the full details of the transaction is probably tax evasion and illegal. I cannot see why the same test would not apply to an application for a mortgage.

James Bailey