The hunt for a reliable passive income often leads private investors to buy-to-let property. Historically this hasn’t been a bad strategy. But with the FTSE 100 now offering a potentially tax-free dividend yield of over 5%, I think the stock market a much more attractive opportunity for income seekers.
Let me explain why.
What’s wrong with buy-to-let?
Recent governments have tightened the screws on small landlords. A stamp duty surcharge of 3% adds an extra £7,042 to the average UK house price of £234,742. Mortgage tax relief is being tapered, which means higher income tax bills for many landlords. And in most parts of the country, house prices remain at historic highs.
In addition to this, landlords face an ever-increasing burden of rules and regulations. And you must also budget for insurance, unexpected repairs, problem tenants and void periods.
When you finally decide to sell your rental property, you may also face a capital gains tax bill — assuming property prices have risen.
I think that renting property can be a good business. But as a private investment on the side, I think it’s hard work, expensive and less profitable than you might expect.
Why I’d buy the FTSE 100 instead
The market slump we’ve seen over the last few weeks has brought down the price of the FTSE 100. At just over 6,000, I think the index probably offers very good value for long-term buyers.
Lower share prices also mean higher dividend yields. At the time of writing, my sums indicate that the Footsie offers a 5.3% dividend yield. That’s well above the historic average for the blue-chip index. Again, this looks cheap to me.
Anyone investing in a FTSE 100 index fund will receive this income split across two payments each year. No hassle. No tenants. Just an automatic cash payment into your account.
Tax avoidance
At the top of this piece, I mentioned that the FTSE could provide a tax-free passive income. Achieving this is simple enough. By holding your stock market investments in a tax-free Stocks and Shares ISA, you can avoid any future income tax or capital gains liabilities.
There’s also a second attraction. Stamp duty on shares is just 0.5%. Dealing charges are low. It’s certainly cheaper to invest in stocks each month than it is to pay letting agency management fees.
What could go wrong?
The yield from the FTSE 100 is made up of contributions from all the dividend-paying companies in the index. This diversification offers a measure of protection from dividend cuts — if one company cuts its payout, it should only have a small impact on the overall index.
The risk here is that a handful of big companies, such as Royal Dutch Shell and HSBC, account for a large chunk of the index’s dividend yield. If one of these heavyweights cuts its payout, then the overall index yield could fall.
Even so, the overall cut to your income would probably be much smaller than if you owned the individual shares.
What I’d do
At current levels, I believe the FTSE 100 provides income investors with a great opportunity to lock in a reliable cash income. When combined with the tax shelter of an ISA, I reckon this could be a good time to start building a passive income fund.