Philip Holdsworth touched on the change in the relief for finance costs in his blog on 12 August 2015, here we look at the new rules in a bit more detail.
The restriction of financing costs for individual landlords of residential property is not a simple reduction in tax relief, but a change from a deduction of interest to a relief that reduces the tax payable (a tax “reducer”). The calculation is therefore very different. This restriction will be phased in from 2017 over four years. This may not only include mortgage interest but also interest on loans to say buy an office from which the letting business is ran from.
The example below shows how a landlord who makes a loss from letting will pay income tax in 2020/21. Such a position may be unsustainable, so it may be wise to consider a change in the lettings business, as discussed below.
Cheryl is a single parent who earns £25,000. She is entitled to child benefit and pays tax at the basic rate. She lets out her former family home for £34,000, and rents a small flat. The let property has a large mortgage attached so the deductible interest is £36,000. Cheryl thinks she won’t be affected by the Summer Budget changes as her marginal tax rate in 2016/17 is only 20%.
Her income remains constant, but in 2020/21 her personal allowance is assumed to be £12,500, and the basic rate band is £37,500. However, in that year all of the interest she pays on her let property mortgage is disallowed as a deduction, and instead she receives a tax credit to set against her tax bill.
Letting income 34,000
Interest deduction (34,000)
Total net income 25,000
Personal allowance (11,000)
Taxable income 14,000
Basic rate band limit 32,000
Property loss carried forward (2,000)
Tax charged at 20% 2,800
Tax charged at 40% –
Tax credit on interest at 20% –
Total tax payable 2,800
Letting income 34,000
Interest deduction Nil
Total net income 59,000
Personal allowance (12,500)
Taxable income 46,500
Basic rate band limit 37,500
Property loss carried forward 0
Tax charged at 20% 7,500
Tax charged at 40% 3,600
Tax credit on interest at 20% (6,800)
Total tax payable 4,300
In 2020/21 Cheryl is a higher rate taxpayer and she loses most of her child benefit because her total income is over £50,000. The tax credit is calculated as 20% of the lower of:
Finance costs not deducted from income (£36,000)
Profits of the property business (£34,000)
Total income exceeding allowances (46,500)
Her lettings business has made an accounting loss of £2,000, but she pays tax of £4,300 of which £2,500 is deducted under PAYE. As her actual finance costs are £36,000 she will be able to carry forward a tax credit of £400 (20% x £2,000) to set-off in a later year.
It should be pointed out that the above example more aimed at owners of larger property portfolios. However, Cheryl’s situation is not impossible especially given that interest rates may rise by 2020/21.
Another example more akin to a landlord with one or two properties is briefly detailed below.
Assume that a landlord pays tax at 40%. At present, their buy-to-let earns £10,000 a year and the interest-only mortgage costs £6,500 a year. Tax is due on the difference on profit so they pay tax on £3,500, meaning £1,400 for HMRC and £2,800 for the landlord.
Fast forward to 2020…tax is now due on your full rental income of £10,000, less a tax credit equivalent to basic-rate tax on the interest. So they pay 40% tax on £10,000 (i.e. £4,000), less the 20% credit (20% of £6,500 = £1,300), meaning £2,700 for HMRC and £800 for the landlord. Their tax bill has therefore gone up by 93%.
In addition, let’s say mortgage rates rise by a small fraction thus lifting the landlord’s mortgage cost to £7,500, while their rent remains at £10,000. They will have to pay £2,500 tax in this scenario, so they make no profit at all.
Going back to Cheryl…Solutions
Cheryl may indeed wish to sell her only let property as she has no other resources from which to reduce her borrowings.
Other landlords may be able to sell part of their property portfolio, or restructure their lettings business in one of the following directions: –
Sell residential property and reinvest in commercial buildings. However, there may be two stumbling blocks here: –
1) The housing market suffered a significant slump in the 2007 recession and although the effects have been mitigated because of more recent positive upturns in the market, a landlord may well be sitting in negative equity.
2) As many residential landlords will also be thinking this then it may affect the prices of commercial properties.
Let the residential property as furnished holiday lettings. There are particular criteria to be met and these criteria may be difficult to fulfil even with the added motivation of further tax advantages.
Transfer the properties into a company. There are many considerations here, some of which are discussed below. But, from April 2016 dividend income in excess of £5,000 will be now be taxed from 7.5% upwards so calculations will be required to consider if this will indeed save you any tax at all. A full review of your personal circumstances is likely.
Any of those options will allow a full deduction of interest and other finance costs from the rents received, but the transition will involve Capital Gains Tax (CGT) and Stamp Duty Land Tax (SDLT (LBTT in Scotland)) costs. Also the mortgage provider must co-operate with the transfer of loans to a company, and it may require higher rates of interest on a corporate loan.
The sale of the properties, or transfer into a company controlled by the individual, will generate capital gains. Capital Gains Tax (CGT) will be due unless those gains can be covered by a relief, or deferred using EIS (Enterprise Investment Scheme) or SITR (Social Investment Tax Relief).
An investment under SEIS (Seed EIS) can also be used to exempt up to £50,000 of gain a year, where the maximum permitted (£100,000) is invested in SEIS shares.
Most CGT reliefs (entrepreneurs’, business asset roll-over, hold-over for gifts) can’t be used for gains made within a property letting business, as letting is not regarded as a “trading business”.
Where there are a small number of properties carrying relatively low gains those could be transferred or sold gradually, and the gains covered by the taxpayer’s annual exemption for each year (£11,100 for 2015/16). Where a property is held in joint names the annual exemption of both owners can be set against their proportion of the gain.
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 EM Ramsay case. 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. It should be noted that the, however, the circumstances of the Ramsay case may not apply to your circumstances and you and your tax adviser will have to draw a conclusion based on your facts.
In order to qualify for incorporation relief in any respect requires the transfer of all assets i.e. all of the residential properties. 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. There is also an averaging relief that can be used to reduce the SDLT when there is an acquisition of multiple dwellings (FA 2003, Sch 6B).
Specialist SDLT/ LBTT advice will be required in all cases. Note: the anti-avoidance rules for LBTT in Scotland are different to those operating for SDLT in the rest of the UK.