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Effect of a fall in property values

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The Bank of England has been putting up interest rates to try and slow down the increase in property prices. There has been a lot of speculation recently about the property market being on the verge of crashing. One of our clients was concerned how a fall in their surgery value would affect them given that one partner is planning to leave in a year's time.

Their property was built for a total cost of £1.2m and this was financed by a loan for the same amount. The practice receives cost rent based on £1.2m and the current open market value of the property is £800,000. There are four partners in the practice who own the property equally.

The value of the property in the accounts will either be shown at cost or based on a valuation which could be the open market value or the cost rent value.

The value of the property in our client's accounts is shown at the cost rent value of £1.2m rather than the open market value of £800,000. If the value in the accounts were at £800,000 then the accounts would show negative equity of £400,000 with corresponding overdrawn partners capital accounts. If property prices fall this practices negative equity would be increased. Equity in a property is the open market value less the balance outstanding on the mortgage. Negative equity occurs when the balance on the mortgage is more than value of the property.

Practices that are funded under the cost rent scheme would normally have a clause in their partnership agreement to say that the value of the property would not be less than the cost rent value. The reason for this is if, as in our client's case, they valued the property at open market value the accounts would show negative equity of £400,000 and each partner would have an overdrawn capital account of £100,000. If a partner left then they would be required to repay this debt. However an outgoing partner should not have to suffer this loss as the practice receives cost rent income based on the value of £1.2m which covers the cost of financing the loan.

Interest on a business loan is allowable for tax relief and GP's can benefit up to 40%. If a loan for a property is more than its open market value then there is an element of the loan which is not secured on an asset. The Inland Revenue could argue that the interest on the excess amount be disallowed for tax purposes. In our example, the client's loan amount is £1.2m, but the property is only worth £800,000 therefore the interest on the excess of £400,000 could be disallowed. If property prices fall then the excess will be higher.

Practices can receive notional rent which is based on the open market value of the property. Most practices move from cost rent to notional rent when the income becomes more beneficial. Normally notional rent is reviewed every three years by the district valuer.

Many practices have gained in the past from their notional rent being greater than the amount of mortgage interest charged on their outstanding loans. This has been due to low interest rates and high property prices. Practices will need to consider the impact of a fall in property prices on the rent they will receive. With the increase in interest rates and potential fall in property prices, practices who receive notional rent may find that their notional rent does not cover the cost of the mortgage interest.

A fall in property prices will not affect the amount a practice receives for cost rent.

Practices may also need to review their current mortgage arrangements if interest rates continue to increase. Practices may want to look at fixed rate mortgages where the rate of interest can be fixed for a period of time. This can protect practices from high interest rates. However practices also need to be aware of early redemption penalties, which will be charged if the mortgage is redeemed early. For example if you fix your mortgage for 10 years and the interest rates go down then you may want to switch to a variable rate which could mean you incur large redemption penalties.

June 2004