It was announced in the Summer Budget 2015 that the taxation of rental would change significantly due to changes in how tax relief on interest costs would work. These changes are to be phased in over four years from 6th April 2017, with the new rules fully in place from April 2020.
What is changing from April 2020?
Under the previous rules, expenditure on mortgage and loan interest and similar costs (this includes arrangement fees etc) were allowed as an expense in calculating an overall rental profit, with tax payable on the net profit, or with the net loss being carried forward against future rental profits. For the remainder of this article, we will describe all of these affected costs as interest.
From April 2020, for people subject to income tax (i.e. not limited companies) with rental income from residential (but not commercial) letting income (excluding furnished holiday lets), interest is no longer deducted from profit before calculating tax. Instead, tax is calculated without reference to interest costs incurred, and then 20% of the interest costs are deducted from the resultant liability. Therefore, tax relief is effectively limited to basic rate relief, irrespective of an individual’s marginal tax rate.
What is changing from April 2017?
For 2017/18, 25% of interest costs are dealt with under the new rules, with 75% being treated as a cost in arriving at rental profit as has historically been the case.
For 2018/19, 50% is subject to the new treatment, with the remaining 50% being treated as a cost, and in 2019/20, 75% of interest is subject to the new treatment with the remaining 25% offset against income.
From 2020/21 onwards, the new rules have full effect.
How will these changes affect my tax liability?
It is tempting to assume that if you are a basic rate taxpayer, that the new rules will not have any impact on your tax payable, since you currently get relief at 20%, and you will still get relief at 20% under the new rules, albeit in a different manner. However, nothing in tax is quite so straight forward. Please note that comparative calculations are based on the post April 2020 period when the new rules are fully in force. In the interim period as the new rules are phased in in four stages, the effect will be proportional.
Example1 – basic rate taxpayer (highly leveraged)
- Ian has employment income of £40,000
- Rental income of £12,000
- Mortgage interest of £10,000
- In 2016/17, Ian is taxed on £2,000 profit at basic rate i.e. £400
- Under the new rules, Ian is taxed on the £12,000 income as follows:
- £3,000 @ 20% + £9,000 @ 40%
- Less £10,000 @ 20%; total £2,200 – an effective tax rate of 110% when he was previously a basic rate taxpayer paying 20%
Example 2 – basic rate taxpayer (lower leveraged)
- Gary has employment income of £35,000
- Rental income of £12,000
- Mortgage interest of £4,000
- In 2016/17 Gary is taxed on £8,000 profit at basic rate i.e. £1,600
- Under the new rules, Gary is taxed on the £12,000 income as follows:
- £8,000 @ 20% + £4,000 @ 40%
- Less £4,000 @ 20%; total £2,400 – an effective tax rate of 30% when he was previously a basic rate taxpayer paying 20%
Example 3 – net loss scenario
- Maureen has employment income of £60,000
- Rental income of £8,000 (vacant period)
- Mortgage interest of £10,000
- In 2016/17 Maureen has no tax to pay (c/f loss)
- Under the new rules, Maureen is taxed as follows:
- £8,000 @ 40% = £3,200
- Less £8,000 @ 20% = £1,600
- Tax payable on loss of £1,600 (and C/f unrelieved interest of £2k)
What can be done to mitigate the impact on me and my income?
As with all things, taking advice as early as possible is important. Although individual circumstances will vary, here are some typical ideas you may wish to consider:
1. De-leverage property portfolio: As you can see by comparing examples one and two above, the impact of these changes is far greater on highly leveraged portfolios (i.e. where interest is a higher proportion of rental income). Therefore you may wish to reduce borrowings in order that your taxable income is more in line with the economic business profit including interest costs.
You may be able to achieve this either by using existing savings which are not giving you a good return in the bank, or by virtue of being due to receive a lump sum from a pension fund or inheritance.Of course, financial advice should be sought before committing large amounts of capital.
Alternatively, you may wish to sell one or more properties in order to release equity to pay down mortgages on other properties.Again, advice should be sought as to the potential Capital Gains Tax payable on property disposals and considering the timing (for example you may wish to transfer some ownership to a spouse, and consider the number of disposals per tax year to maximise use of Capital Gains Tax annual exemption).
2. Switch borrowing to commercial property/Furnished Holiday Lets: The new rules apply only to residential lettings, so if you are able to secure borrowings against commercial property or qualifying furnished holiday lets which you own or may consider investing in, then this would reduce or remove the impact of these changes.
3. Invest via a limited company: The new rules do not apply to limited companies, so if you hold your portfolio via a company, then this will avoid these rules entirely. However, there are downsides. Firstly, if you sell a property in the company in the future, the company will pay corporation tax on the gain. If you want to access the proceeds personally, then you will need to pay either income tax or capital gains tax to extract the money. However, if you wish to reinvest in a new property or alternative investment, then this is not the case. On the plus side, undrawn profits are charged only to corporation tax (currently 19%) and not higher rates of income tax.
Also, for existing portfolios, there is likely to be a capital gains tax and/or stamp duty land tax cost in moving properties which are currently in personal ownership, so again, professional advice should be sought.It may be possible to avoid this for large portfolios which are run as a business.
If you would like to discuss these changes in more detail, please get in touch with your usual contact at CRM. All of the above potential planning options have possible pitfalls so it is important to seek advice before acting.
This document is prepared as a generic guide purely to the tax aspects of these rules and does not constitute tax, financial or any other advice. The applicability of tax rules will depend on your individual circumstances. You should consult a suitably qualified and experienced professional before making decisions. No responsibility can be taken for any loss arising from action, or inaction, taken as a result of the information in this guide. This factsheet is based on our understanding of the legislation as at July 2017.