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What are the changes to buy-to-let mortgage interest tax relief for landlords?

Section 24 and the restriction in mortgage interiest and finance costs have been a hot topic for landlords in recent months. Let's take an indepth look at the changes being phased in by HMRC

This has been the hot topic in recent times for property landlords: Section 24 and the restriction in mortgage interest and finance costs.  Certainly, here at RITA4Rent, this has been the biggest source of tax confusion for prospective landlord clients that we speak with, since the changes began being phased in by HMRC.

Rita4Rent Michael Wright This Guide was produced by Michael Wright, Landlord Tax Expert at Rita4Rent, who are specialist landlord tax advisors, and the sole recommended tax advisors of the Residential Landlords Association. Michael now writes for Listentotaxman.com on matters relating to property and landlord tax. RITA4Rent are very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit the Rita4Rent website for contact details.

Rita4Rent Michael Wright This Guide was produced by Michael Wright, Landlord Tax Expert at Rita4Rent, who are specialist landlord tax advisors, and the sole recommended tax advisors of the Residential Landlords Association. Michael now writes for Listentotaxman.com on matters relating to property and landlord tax. RITA4Rent are very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit the Rita4Rent website for contact details.

To summarise briefly, the tax relief that landlords of buy-to-let residential properties were able to claim for finance costs prior to April 2017 will, by April 2020, be restricted to the basic rate of income tax. Rather than an immediate change, the new rules have been implemented annually on a gradual basis.

How was mortgage interest tax relief calculated historically for landlords?

In the past, if you were a buy-to-let landlord with a mortgage on your property, you previously enjoyed significant tax relief by offsetting your entire mortgage interest payments. So, prior to April 2017, all the interest and finance costs that you paid as part of your monthly mortgage payment was deducted from your rental income to calculate profit before you paid tax on it.

To illustrate, if you made £10,000 a year in rental income and your annual mortgage interest payments totalled £5,000 then you could deduct the £5,000 from your rental income. So you would only pay tax on the remaining £5,000. If you were a basic rate taxpayer, then your tax bill would be £1,000 (20% of £5,000). If you were a higher rate taxpayer then your tax bill on rental income would have been £2,000 (40% of £5,000).  Of course, this is a simple illustration, and there could well be numerous other costs you could claim.

What are these new rules relating to mortgage interest tax relief for landlords?

In April 2017, or more specifically from the start of the 2017-18 tax year, the new “Section 24” system has been phased in on a gradual basis. For every tax year during the transition period, the percentage of your mortgage interest payments that you can deduct from your rental income decreases by 25%, and the portion of those interest payments that qualify for the new tax credit increases by 25%.  By 2020, you won’t be able to deduct any of your mortgage interest payment from your rental income to gain tax relief. Instead, the entire sum of your interest payment will qualify for a new tax credit.

Now if we go back to the simple illustration above. The same landlord receiving £10,000 in rent and paying £5,000 in mortgage interest will end up owing tax on the full £10,000 of rental income (again, assuming no other expenses for simplicity). The amount will still depend on whether they pay tax at the basic (20%) or higher (40%) rate. So Brian, as I'm calling our basic rate taxpayer owes £2,000 in tax while Henry, our higher rate taxpayer, £4,000.  However, remember that tax credit I mentioned? Both Brian and Henry will then be able to deduct £1,000 from their tax bill due to the 20% tax credit (one fifth of the mortgage interest amount). This leaves Brian, our basic rate taxpayer, with exactly the same tax bill as previously (£2,000 - £1,000 = £1,000). For Henry, our higher rate taxpayer, the final overall tax bill on his rental income will be some 50% higher than previously (£4,000 - £1,000 = £3,000).

Do these changes affect basic rate taxpayers?

Possibly. The problem is that your rental profit is now inflated. The danger therefore, is that you could actually be forced into the higher tax band by default. This is because you’ll now need to declare the total rental income as your rental profit (again, we'll ignore other rental costs for simplicity).  The effect of this could be to push your total income into the higher rate tax bracket (£50,000 in 2019-20), depending on your income from other sources, such as your salary or pension.

If we go back to our illustration of our landlord with £10,000 of rental income and £5,000 of mortgage interest, if Basic Rate Brian's other earnings for the year were £45,000 then, historically, adding the £5,000 of profit, he would have paid all of his tax at the basic rate. Not so with the new tax credit. Adding all £10,000 of the rental income will see £5,000 taxed at the basic rate and £5,000 at higher rate before applying the new tax credit. So that's £1,000 + £2,000 - £1,000 (tax credit) = £2,000. Brian is still paying less than he would if all of his income was taxed at higher rate, like Henry (£3,000). However, he is also paying double the £1,000, he would have paid under the traditional way of calculating rental profit.

The calculations using the new measures can be quite complicated. We would recommend that you consult with experienced property tax advisors, such as ourselves, to discuss your own situation.

It is worth pointing out too, that given the fact your rental profits will now be “inflated” due to these new rules, this could have far reaching consequences, such as affecting your child benefit claim and/or tax credits and/or student loan deductions. 

What is going to be the effect on me as a higher rate taxpayer?

Those landlords in higher tax brackets will be paying tax on a percentage of the total rental income, rather than the rental income minus annual mortgage interest payments. As the only tax relief they’ll receive is the tax credit instead of the entire amount of mortgage interest, all higher rate taxpayers with mortgaged properties will pay more tax than prior to April 2017.

Not only will those landlords who pay tax at 40% find it harder to make a profit as a result of these changes (this is the intention of the legislation) but, for some, there will be a real risk of negative earnings, whereby a landlord with a small profit margin may find that they are “in the red” after tax i.e. actually losing money on their property rental.

To reiterate, I would urge anyone who thinks that may include them to consult with property tax professionals such as ourselves, to do some planning and discuss potential mitigation.

Are all landlords affected?

Not all landlords. Only landlords that let residential properties as an individual, in a partnership or trust are affected.  And of course, you would need a mortgage to be affected naturally.

Who is exempt from the changes?

Landlords of furnished holiday lettings and those who hold properties within a limited company structure will continue - for now -  to receive tax relief on the interest, and any other finance costs, in exactly the same way as prior to April 2017.

Does the restriction apply solely to buy-to-let mortgages?

Unfortunately, it is not just mortgage interest, it is also finance costs. So this included loans to buy, say, furnishing, and overdrafts or alternative forms of finance are all caught by the restriction in interest relief.

Where the mortgage is for a dual purpose, say for both residential and commercial properties, the interest must be apportioned to work out the finance costs for the residential properties only. The same approach applies where the loan is partly for a self-employed trade and partly for residential property. And, yes, also if you re-mortgage your own home.

Is there anything that I can do to avoid the new charge?

There are various options which may or may not be viable.  If you are a higher rate taxpayer and you have a lower earning spouse then it would make financial sense to transfer a major share of the property to them.  Please do be aware that you cannot simply change beneficial ownership of a property by filing a tax return. You will require tax and legal advice in completing a Declaration of Trust or altering title to reflect any change before you notify HMRC. The change also cannot be made retrospectively.  For those who are close to the higher rate band, a simple pension contribution or gift aid donation may help a lot.  And of course, as we have written about before, the hot topic is whether or not holding your properties in a limited company is a viable option moving forward. 

Can landlords incorporate to keep all of their mortgage interest relief?

As discussed above, the changes in tax relief only affect private landlords, those who own their properties as individuals or couples, rather than companies. By setting up a limited company, landlords will be able to continue to pay tax on rental income after deducting the mortgage interest cost, and at a lower rate too. However, if you’re considering this strategy, it is vital to research things thoroughly and seek professional advice at an early stage. The main consideration is that the process of transferring property ownership from personally held to a limited company is considered a sale, even if no money changes hands. This means that you become liable to both Capital Gains Tax (CGT) on your profit AND stamp duty (SDLT or LBTT).

Of course, these may be outweighed by the tax savings - this is where financial advice is crucial. If your property rental already operates as a business then it MAY be possible to incorporate without the need to pay CGT and Stamp Duty. This is something that we have explored in a recent article. You should also consider that companies are unlikely to get quite the same choice of mortgages and that, if you incorporate, your financial affairs will become more complex, though the gap is closing and your accountant can take much of the pain of compliance away.

Whilst this is not a definitive statement, but what we see here at RITA4Rent most commonly, is landlords preferring to keep existing properties held personally, but making additional purchases via a newly formed limited company. 

Conclusion

This really has been a hot topic in recent times, and if you have not already reviewed your portfolio and its current structure, now is the time.  The changes to mortgage interest tax relief from April 2017 and fully implemented from April 2020, mean that all higher rate taxpayers with mortgaged properties, owned jointly or as individuals, will pay more in tax. A percentage will be in the unfortunate position of tax bills outweighing profit, as traditionally calculated.  Some basic rate taxpayers will also be caught by the restriction as the new tax credit on mortgage interest artificially inflates their rental profit and pushes them into higher rate. All of these outcomes are the clear intention of UK Government policy, in an attempt to push private landlords out of the housing market.  Despite attempts to overturn Section 24, it would appear it is here to stay at present.

Landlords should consult with a property tax adviser, such as ourselves (at Rita4Rent [insert tracked link]), to discuss possible ways to mitigate the new law.  As the changes only affect private landlords, many are now setting up their own limited company and/or incorporating their existing portfolios to mitigate the impact of the tax changes. This trend is likely to continue for the foreseeable future but requires careful planning and expert advice.   As we always say, care must be taken to ensure you are making the right decisions for the right reasons.  A limited company is a big decision, and is not a one-size-fits-all solution, and your decisions should not be solely guided by tax.  As the old saying goes, don’t let the tax tail wag the dog!

Rita4Rent Michael Wright This Guide was produced by Michael Wright, Landlord Tax Expert at Rita4Rent, who are specialist landlord tax advisors, and the sole recommended tax advisors of the Residential Landlords Association. Michael now writes for Listentotaxman.com on matters relating to property and landlord tax. RITA4Rent are very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit the Rita4Rent website for contact details.

This article was published in our Guides section on 04/11/2019.

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