Rental Properties and Mortgage Interest Relief
A Summary of the Rules/Issues and Planning Suggestions for BTL Landlords.
Higher rate tax relief is being restricted for buy-to-let landlords on the costs of finance, such as mortgage interest, from 6 April 2017 onwards.
Prior to April 2017, tax is payable on your net rental income after deducting allowable expenses including mortgage interest. This meant that landlords paying higher (40%) or additional (45%) rate tax could claim tax relief at their highest rate. However, from April 2020 tax relief can only be reclaimed at the basic rate (20%), whatever rate of tax the landlord pays. The rules are being phased in over 4 years commencing April 2017.
The change will be introduced gradually from April 2017 as follows:
|Year||% of costs deducted from profits||% of costs available as a basic rate deduction|
Who is affected?
These new rules only apply to individuals with residential property businesses.
They do not apply to companies.
They do not apply to land and property dealing or development businesses, commercial lettings or furnished holiday lets.
Complications for basic rate taxpayers
If you are currently a basic rate taxpayer, you may find that you are a higher rate taxpayer, once the finance costs are disallowed in your rental accounts.
Your tax liability depends on your other income and the amount of finance costs that are added back.
You will not know whether the adjustment will take you into higher rate tax without going over a series of steps in order to work out the effect of the change.
If you do become a higher rate taxpayer after arriving at your rental profits, you will lose higher rate tax relief on your finance costs.
You continue to receive basic rate tax relief on your other costs.
The increase in rental profits will lead to an increase in your total income for tax.
The knock on effects depend on your personal circumstances, other income, capital gains and other reliefs.
For example, there is an impact for anyone claiming tax credits or if you or your partner claim child benefit and the change increases your income above £50,000, child benefit can be clawed back under the Higher Income Child Benefit Charge (HICBC).
You could find that you are paying tax at 40% or higher or that capital gains are taxed at 28% instead of 18%.
You may be able to reduce your taxable income if you carry back pension contributions or Gift Aid donations from the next year.
The basic rate deduction is up to 20% of the disallowed finance costs. The deduction is restricted in some circumstances, such as the following:
When property profits are less than finance costs, the deduction is limited to 20% of the property profits. The reduction does not reduce tax payable on other sources of income.
When there are property losses brought forward these must be set against property profits and could reduce the taxable profit to less than the finance costs. Here the deduction is limited to 20% of the taxable profits.
When total income (excluding any savings or dividend income which are taxed as top-slices) is low, so that some or all of the rental profits fall within the personal allowance, the deduction is restricted to 20% of the profits that are actually taxed.
When there is a restriction, any finance costs which have not been used to calculate the basic rate deduction in one year can be carried forward and added to the finance costs of the following year.
• House is bought for £300,000
• 80% mortgage is taken for £240,000
• Mortgage interest assumed at 4.5% annual mortgage interest is £10,800
• Rental yield is assumed at 5%, annual rent is £15,000
Basic Rate Taxpayer
A basic rate tax payer on the face of it will not pay any more tax under the new rules, but that’s not the whole story.
The new rules change the way income is calculated. Income is now before deduction of any mortgage interest. In the above example, in 2016-17 (before the new rules), your income was £4,200. In 2020 your income is deemed to be £15,000.
For example, if a person has £35,000 of employment income and rental income of £15,000 and mortgage interest is £10,800.
• Under the old rules the net profit of £4,200 and £35,000 employment income would all be taxed at the lower rate of 20%.
• Under the new rules, from 2020, the income from rental of £15,000 and employment income of £35,000 would even after the personal allowance take the taxpayer into the higher rate tax bracket of 40%. (currently income greater then £42,385).
This increase in income could also affect claims for Child Benefit and Income Tax Credits.
*The reduction in mortgage interest allowance is 0% in 2016-17, 25% in 2017-18, 50% in 2018-19, 75% in 2019-20, 100% in 2020 and beyond.
Higher Rate Taxpayer
The tax impact of the new interest deduction rules will be a significant increase to the tax bill for higher rate taxpayers. In 2020, a higher rate tax payer would pay £2,160 more tax.
*The reduction in mortgage interest allowance is 0% in 2016-17, 25% in 2017-18, 50% in 2018-19, 75% in 2019-20, 100% in 2020 and beyond
Should landlords now incorporate???
It depends on a number of factors such as how many properties you hold, whether you need the income quickly and how long you want to hold the properties for and your individual circumstances.
Limited companies are not affected by the new Mortgage interest relief restriction coming in from April 2017. Interest for limited companies is classed as a business expense and fully deductible against income.
Companies pay corporation tax at a fixed rate irrespective of the size of the profits. The Corporation Tax rate is currently at 20% reducing to 17% in 2020. This makes the tax rate very attractive compared to 40% for higher rate tax payers and 45% for additional higher rate taxpayers.
The question is how the money in the company is passed to the individual. If the money is taken out of the company as a dividend, then from April 2016 only the first £5,000 of dividend income is tax free. Any dividends taken out in excess of this will either be charged at 7.5% for a basic rate taxpayer 32.5% for a higher rate taxpayer or 38.1% for an additional higher rate taxpayer. This tax is after the corporation tax at 20% has been paid.
The money could be taken as a salary, however the company would have to operate PAYE and pay Employers National insurance contributions on any salaries paid. This usually in most circumstances works out more expensive than paying dividends.
Companies do also not benefit from the annual allowance of £11,100 against capital gains. So extracting the money for a sold buy to let property could be less tax efficient than holding the property as an individual.
As you have to pay the 20% corporation tax on any gain, no annual allowance is given and you have to pay tax on extracting the money from the company, whereas even a higher rate taxpayer only pays 28% on any gain from the sale of a buy to let as an individual. Companies also have to prepare accounts to be filed with company’s house, prepare and file corporation tax returns which can be more onerous than self-assessment returns.
Interest rates charged on mortgages to companies have historically been higher than to individuals so further investigation of the comparison of the rates charged should be considered alongside the tax implications.
Transferring a current buy to let property into a limited company can trigger stamp duty and capital gains tax charges at the time of transfer so advice should be sought before undertaking such a transaction.
If the entire property lettings business is transferred to a company in one go, in return for shares, incorporation relief (TCGA 1992, s 162) may be available to roll the gains into the value of those shares. Incorporation relief can apply to a significant property lettings business, as determined in the Ramsay case (see below). No claim is required as incorporation relief is applied automatically if all the conditions are met, but it would be advisable to make a full disclosure on the tax return for the relevant year.
The Ramsay v HMRC case gives precedence for landlords to take advantage of Incorporation relief as long as it can be demonstrated that they spent at least 20 hours per week on their property and as such proved that they were in fact in business.
Judge Roger Berner said in the appeal hearing: “I am satisfied that the activity undertaken in respect of the Property, again taken overall, was sufficient in nature and extent to amount to a business for the purpose of s162 TCGA. Although each of the activities could equally well have been undertaken by someone who was a mere property investor, where the degree of activity outweighs what might normally be expected to be carried out by a mere passive investor, even a diligent and conscientious one, that will in my judgment amount to a business. I find that was the case here. For the reasons I have given, I allow this appeal.”
So, what does this mean for you? If you can prove that you work with your properties on a daily basis (at least part-time) then you may be allowed to incorporate your property business without having to pay CGT.
If you are working in another business or are employed then you will find it very difficult to prove your case for incorporation relief.
A further consideration is that after the properties have been transferred, then upon a further sale of any of the properties then no CGT tax free allowance will be available as this is an exemption offered to individuals only. In addition, once sold any remaining cash after any outstanding lending is settled belongs to the company. If you want your hands on this cash then the cash will need to be extracted from the company which (as you have probably guessed) will potentially incur an additional income tax bill.
Where the properties are transferred to a company, that company will have to find the funds to pay the SDLT or LBTT charges.
Where the property lettings business has been carried on by a family partnership there may be relief from SDLT / LBTT on the incorporation of that partnership.