Interest Relief On Properties

Director’s Loan Accounts
July 9, 2016

Interest Relief On Properties

Who is likely to be affected

Individuals that receive rental income on residential property in the UK or elsewhere and incur finance costs (such as mortgage interest), excluding where the property meets all the criteria to be a furnished holiday letting.

General description of the measure

This measure will restrict relief for finance costs on residential properties to the basic rate of Income Tax. This will be introduced gradually from 6 April 2017.

Finance costs includes mortgage interest, interest on loans to buy furnishings and fees incurred when taking out or repaying mortgages or loans. No relief is available for capital repayments of a mortgage or loan.

Landlords will no longer be able to deduct all of their finance costs from their property income to arrive at their property profits. They will instead receive a basic rate reduction from their income tax liability for their finance costs.

Landlords will be able to obtain relief as follows:

  • in 2017 to 2018 the deduction from property income (as is currently allowed) will be restricted to 75% of finance costs, with the remaining 25% being available as a basic rate tax reduction
  • in 2018 to 2019, 50% finance costs deduction and 50% given as a basic rate tax reduction
  • in 2019 to 2020, 25% finance costs deduction and 75% given as a basic rate tax reduction
  • from 2020 to 2021 all financing costs incurred by a landlord will be given as a basic rate tax reduction

 

For a 45pc taxpayer, every £100 of mortgage interest they pay costs just £55 after claiming tax relief, but this will rise to £80 when the changes are fully implemented from April 2020.But we insist that there’s a way around the problem – by investing through a limited company.

So how does it work?

The main tax benefit of holding properties within a company is that rental profits are taxed at the corporation tax rate of just 20pc. The Government announced this week that the rate would fall to 19pc in April 2017, and then to 18pc in April 2020.

Landlords can take profits from the company as dividends and even the rise in the dividend tax (see page 5), also announced this week, will not outweigh the savings. From April next year only the first £5,000 of annual dividend income will be exempt from tax. Above this amount, basic-rate taxpayers will pay 7.5pc, higher-rate taxpayers will pay 32.5pc, and additional-rate taxpayers will pay 38.1pc.

 

So let’s take the example of a higher-rate taxpayer (40pc) who receives £50,000 a year in gross rental income. He pays £20,000 interest on his mortgages and has other rental expenses worth £10,000. His total rental profit before tax is £20,000.

If he owned the properties personally in 2020 when the full changes come into force he would owe £12,000 in tax on his rental profit, giving him £8,000 take-home profit.

 

If he held the properties in a company he would pay just £3,600 tax (18%) on the rental profit, thanks to the 18pc corporation tax rate.

This leaves the company with post-tax profit of £16,400. If this was paid to the landlord as a dividend the additional tax due would be £3,705, giving a total tax charge of £7,305. The landlord’s take-home profit would be £12,695 – £4,695 more.
So let us consider three examples of somebody who owns a property worth say, £250,000 receiving a rent of £17,000 before letting and other costs of £2,000 and who has a mortgage of £180,000 with an interest cost of £9,000.  Thus profit before rental interest is £15,000 and after interest it is £6,000.

Note the proposed buy to let restriction relates to “finance costs” not just interest – so lender application fees would appear to be covered by the proposals too.

Example 1

Mr A earns a salary (or if self-employed has a taxable profit) of £25,000.   His “before” and “after” situation is as follows.

  % Tax Current Rules Budget Proposals
    £ Tax £ Tax
Salary   £25,000   £25,000  
Taxable rental profit   £6,000   £15,000  
Taxable income / profit   £31,000   £40,000  
    Tax band Tax band
Tax at 0% £12,000 £0 £12,000 £0
  20% £19,000 £3,800 £28,000 £5,600
Less tax relief on interest 20%     £9,000 -£1,800
Total tax     £3,800   £3,800

In other words no change in the overall tax liability for this basic rate taxpayer.  If Mr A was an employee suffering PAYE on his salary he will have already paid £2,600 of PAYE leaving him £1,200 of tax to pay on his rental income – i.e. 20% of his taxable rental profit of £6,000.

Example 2

Miss B earns a salary of £75,000.  Her position is altered as follows:

  % Tax Current Rules Budget Proposals
    £ Tax £ Tax
Salary   £75,000   £75,000  
Taxable rental profit   £6,000   £15,000  
Taxable income / profit   £81,000   £90,000  
    Tax band Tax band
Tax at 0% £12,000 £0 £12,000 £0
  20% £38,000 £7,600 £38,000 £7,600
  40% £31,000 £12,400 £40,000 £16,000
Less tax relief on interest 20%     £9,000 -£1,800
Total tax     £20,000   £21,800

In this case her total tax bill has gone up by £1,800 due to the restriction on interest relief to 20% on £9,000 of interest expense – so £9,000 x (40% – 20%).  She will have already paid £17,600 of PAYE and so the tax on her net rental income of £6,000 has effectively risen from £2,400 (£20,000 – £17,600) to £4,200 (£21,800 – £17,600) – an effective tax rate of 70% on her net profit.

Example 3

Mrs C might hope that she is not affected by the change since her salary is £43,000 – which together with her rental profit of £6,000 leaves her below the higher rate threshold of £50,000.  But as the following example shows she does get caught by the restriction.

  % Tax Current Rules Budget Proposals
    £ Tax £ Tax
Salary   £43,000   £43,000  
Taxable rental profit   £6,000   £15,000  
Taxable income / profit   £49,000   £58,000  
    Tax band Tax band
Tax at 0% £12,000 £0 £12,000 £0
  20% £37,000 £7,400 £38,000 £7,600
  40% £0 £0 £8,000 £3,200
Less tax relief on interest 20%     £9,000 -£1,800
Total tax     £7,400   £9,000

Mrs C will suffer an additional £1,600 of tax as her gross income including her rental profit before tax deduction will be £58,000 – so her additional tax is £8,000 x (40% – 20%).

For landlords who want to grow their portfolio it would be even more tax-efficient to hold the properties in a company, not distribute dividends and reinvest the profits.

There are other factors to take into consideration however. There would be a personal income tax charge if you wanted to take money out of the company, at your personal tax rate.

When you wanted to sell the properties corporation tax would be due on the profits. And when you closed the company you could take out any excess money as a capital payment but capital gains tax (CGT) would be due. This would apply on selling the property even if you hadn’t used a company structure.

Note that if you buy a property worth more than £500,000 in a company there is a 15pc stamp duty charge – much higher than the rates for personal investors – however broad exemptions are available.

There are also fewer mortgage products available to companies than individuals, so rates may be worse.

If you already own properties it is not easy to transfer them into a company. This can be considered a disposal for CGT purposes, so you could face a tax bill. There would also be a potential stamp duty charge.

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