Tax relief for residential properties can affect you if you let out properties; let us explain.
HMRC recently introduced a new restriction on the amount of mortgage interest relief that is available to rental properties.
From the 6th April 2020, tax relief for finance costs will be restricted to the basic rate of income tax which is currently at 20%.
Tax relief for residential mortgages is given as a reduction in tax liability and not a reduction in taxable rental income.
These changes have slowly been introduced since the year to 5th April 2018 and by the year to 5th April 2021, the new system will have taken over.
In fact, many independent landlords that had small profit margins before this restriction may find that they now make losses, potentially losing a lot of money due to the new changes.
For landlords that are currently making a profit, they will need to now declare the rental income used for interest payments as their own income.
This means that it may move you into a higher tax bracket, potentially causing a tax bill that in a bad case is increased by tenfold from the standard 20% lower tax rate bracket.
If you own a property letting business then this may cause concern for you.
The reality is that if you’re able to restructure your borrowings, you can still have substantial tax benefits to running your business.
This change generally affects private landlords the most, but by setting up a rental business you can mitigate much of the changes that will become in full effect by 2020.
In this article, we’re going to delve deeper into the subject of tax relief for residential mortgages and try to offer some advice on how to cope with the new changes, while also giving examples to help illustrate the points more clearly.
The New Tax Relief on Mortgage Restriction
Since the year to 5th April 2018, the restriction designed to limit the mortgage interest relief for individual landlords has slowly been phasing in.
During the tax year of 2017/2018, 75% of mortgage interest was fully allowable whereas the remaining 25% was available at the basic rate.
In 2018/2019 the split will be 50/50, in 2019/2020 the split will be 25/75, and in 2020/21 it will fully move over to the basic rate,
The change is designed to discourage the rise in the numbers of private landlords by reducing property mortgage interest relief to the basic rate of income tax.
The restriction essentially removes all deductions for the finance costs before any tax is calculated.
To reduce the individual’s tax liability, a tax deduction is offered instead.
This can increase the individual’s tax liability by up to 20% of the mortgage interest.
This restriction hurts expensive properties the most.
Properties which requires large mortgages to purchase are common victims here, and landlords may be forced to pay income tax on loss making rental properties just to keep up.
In response to this new restriction, it’s become vital to maximising the amount of interest against which relief can be claimed.
As an individual property letting business, it has become essential to adapt to these changes in order to remain a profitable property business.
“As an owner / manager business we needed an accountant/tax adviser that can come to us at a time and place that fits in with our busy schedule. WAGNER Associates provides that service, ensuring quick, no fuss tax and accounting support”.
Graham ChristieMD, GDC Design Limited
Maximising Tax Relief on Mortgage Interest
Those who own more than their main residence will likely find that they’re unable to maximize the amount of tax relief that they can claim on mortgage interest.
HMRC only allow interest on a loan taken out for business purposes to be deducted when calculating the profits of that business.
As such, if you’re able to swap a business loan and a non-business loan, you’ll be able to increase the amount of interest relief that you can claim.
If you purchase your main residence with a mortgage then it doesn’t count as a business loan.
This is where the purpose of the loan becomes an important point.
You won’t receive mortgage interest tax relief.
However, a loan taken out for the purpose of funding a property letting business is considered a business loan.
This means that the mortgage interest is an allowable expense.
Unfortunately, this doesn’t always work because it’s not simple to swap a non-business loan and a business loan by simply increasing the amount of borrowing on the rental property and using your money to pay off the mortgage on your main residence.
This is because HMRC has reason to claim that, given your circumstances, you didn’t increase the borrowing for the sake of business but instead for the sole reason of allowing the business owner to withdraw more cash.
However, there is a useful exception to this.
If the borrowing on a business property is actually lower than what the market value of the property is when you first added it to your business, then swapping is very possible.
This is because the market value of the property when you first introduce it to the business is known as your capital contribution.
This means that the contribution is business-related and that any borrowing that funds the contribution is seen as a related loan.
If the borrowing on the rental property is lower than the property’s market value at the date it was introduced to the business, then the borrowing can actually still be increased up to that value.
It will also provide full interest relief subject to the mortgage restriction introduced even if the cash is raised against the mortgage of the main residence.
Can You Claim Tax Relief on Mortgage Interest?
Let’s imagine that your main residence is worth £400,000 with a £200,000 mortgage on the property.
You also have a rental business and the rental property is worth £350,000 with a £200,000 loan secured against it as well.
In this situation, you’ll be able to claim interest relief on the £200,000 loan on the rental property but not the £200,000 on your main residence.
If the rental property is worth £300,000 when you first started to let it as part of your business, then you will be able to increase your business borrowings from just £200,000 to £300,000.
Since borrowing £300,000 doesn’t exceed the market value of the rental property when you introduced it to the business, you’ll be able to claim interest relief on the full £300,000 rental property loan.
You can even use the extra £100,000 of cash to reduce the borrowing on your main residence or spend it on something else of your choice.
However, if you do decide to use that money to reduce your main residence loan, it does mean that you’ll still have £400,000 of borrowing on the two properties.
The difference is that instead of having just £200,000 of the loan as eligible for interest relief, £300,000 of the loan now benefits.
This essentially means that you’re saving 50% more tax than before which could offset some of the impact caused by the new mortgage interest relief restrictions.
Confused ? Don’t be !
It’s understandable if this topic is confusing especially with relatively new independent landlords that are uncertain about how tax relief for residential mortgages works.
As a result, it’s always a great idea to contact a specialist to help explain the concepts in more detail and also offer savings to you and your rental business.
A tax specialist will be able to assist you by offering impartial advice on how to maximise what you can claim in terms of tax relief and also help you reduce losses should you be forecasted to lose money in the tax years when the change starts to fully take place.
Some Final Words
The topic of tax relief for residential mortgages is a difficult one.
Many landlords are now focusing on setting up their own limited companies in an attempt to reduce the impact they are experiencing from the new system.
Although the change has yet to fully take effect, many landlords are already struggling especially if they had lower profit margins in the past.
Potential fix, but …
Although setting up a limited company is a potential “fix” for independent landlords that have been hit by this change, it’s still important to realize that transferring property ownership from yourself to a limited company does count as a sale.
This means you may be required to pay capital gains tax if the property has risen in price.
As a result, it’s always best to speak to an expert on the subject to see what they have to say first.
Though setting up a limited company seems to be the go-to strategy to mitigate the damage caused by these new changes, there may be alternatives.