From April 2017 there will be a reduction in the amount of mortgage interest relief available to individual buy-to-let landlords against their rental income.
At the moment mortgage interest relief is fully deductible against rental income so that landlords liable to income tax at the higher and additional rates of income tax effectively receive tax relief at 40% or 45%. However, under the new rules the rate at which interest relief is given will gradually fall to the basic rate of 20% by the tax year 2020/21.
The effect of this change in many cases will be to increase the amount of income tax paid by buy-to-let landlords thus reducing their net of tax rental income.
Depending on the amount of their UK source income, non-UK resident buy-to-let landlords will also be affected.
This change does not affect rental income received by companies but there are other significant UK tax issues involved in acquiring buy-to-let investments through a UK or non-UK company.
We set out more detail on the change below. Draft legislation was published in the Finance Bill on 15 July 2015.
How does mortgage interest relief for buy-to-let landlords work at the moment?
The basic principle is that buy-to-let landlords are liable to income tax only on net rental income after deducting costs, including mortgage interest. The deduction applies not only to the cost of interest on loans taken out to purchase the buy-tolet property itself but also on loans to buy furnishings and fees incurred when taking out or repaying such mortgages or loans. (There is no relief for repaying the capital of such loans.) These deductible costs are referred to as “finance costs”.
Under the current rules individuals who pay tax at the higher or additional rates of 40% or 45% respectively receive tax relief in respect of mortgage interest payments at those higher and additional rates. This is shown in Example 1 in the box below.
Landlord (L) receives gross rental income of £300,000. He is subject to the additional rate of income tax of 45% on all his rental income.
L pays mortgage interest of £100,000 which is fully deductible from his gross rental income. He therefore receives tax relief of £45,000 (45% of the £100,000 mortgage interest).
L’s net rental income after finance costs is £200,000.
His total tax liability is 45% of the £200,000 net rental income, i.e. £90,000. L’s net receipts after tax and finance costs is therefore £110,000.
How will mortgage interest relief change?
In future landlords will still be entitled to relief for finance costs but this will only be at the basic rate of income tax ie at 20%.
The way in which the deduction for buy-to-let finance costs will work once the changes have been fully phased in (from 2020/2021 onwards) is set out in Example 2 in the box below.
Based on the Budget Day announcements and once the new restriction has been fully phased in (from tax year 2020/21 onwards) L will no longer be able fully to deduct his finance costs against his rental income when calculating his income tax liability.
However, he will be entitled to relief against rental income of 20% of his finance costs.
Therefore, based on the figures in Example 1, L will still pay income tax at 45% on rental income of £200,000 net of finance costs (ie income tax of £90,000 on this element).
But now L will only be entitled to tax relief at 20% in respect of his finance costs of £100,000 (ie he will receive tax relief of £20,000) leaving him with a tax liability of 25% on the remaining £100,000 of rental income (ie compared to the position in Example 1, L will pay additional income tax of £25,000).
Total income tax in Example 2 would therefore be £115,000.
L’s net receipts in Example 2 after tax and finance costs would go down by £25,000 from £110,000 (in Example 1) to £85,000.
When will the restriction on relief for finance costs start to apply?
The restriction on relief for finance costs described above will be introduced gradually from 6 April 2017 as set out in the table below. From 6 April 2020 relief will be available only at the basic rate of income tax.
Click here to view table.
Will landlords still be able to carry losses forward to future years?
It will continue to be possible to carry forward excess finance costs in a particular tax year to be set against the income of future years.
Are furnished holiday lettings affected by the restriction on deductibility of finance costs?
No. It will continue to be possible to offset finance costs incurred in respect of furnished holiday lettings fully against the income received. In such cases income tax relief will therefore continue to be potentially available at the higher and additional rates.
Are there any other changes affecting landlords of residential property?
At present landlords of furnished properties can deduct 10% of their rent from their profit to account for wear and tear, regardless of their actual expenditure. From April 2016 this allowance will be replaced by a new system under which landlords of residential property may only deduct costs which they actually incur.
How does the restriction of relief for finance costs affect non-UK resident buy-to-let investors?
Non-UK resident investors in UK buy-to-let property will also be affected by the restriction of relief for finance costs if their gross (before tax) UK source income is above the basic rate band. For the current tax year of 2015/16 the basic rate band is £31,785 but depending on their circumstances a person may need income of more or less than this amount to come into the higher rate tax band and so be affected by these changes.
A non-UK resident individual in the Non-Resident Landlord Scheme (which allows rental income to be paid without any withholding, and the landlord then pays the tax due on his or her UK tax return) will still need to check their UK tax position and reporting obligations in light of these changes.
What is the position in relation to UK buy-to-let investments held through companies?
Because UK resident companies are liable to income tax only at the corporation tax rate (currently 20% but going down to 18% by April 2020) and non-UK resident companies are only liable to basic rate income tax, such companies are not affected by the restriction in mortgage interest relief.
However, there are other significant tax issues to consider when acquiring buyto-let investments through UK or non-UK resident companies and advice is needed in each case to determine whether or not this would be a suitable option. There will be instances where UK resident shareholders of certain companies could still be caught by these changes under anti-avoidance rules.
The extent to which the above changes will affect individual landlords will depend in each case on what proportion of income is paid in interest and on the rates at which the individual landlord is paying tax.
The UK tax treatment will also depend on how the buy-to-let investment is held – whether through a company and/or trust or directly in the investor’s own name.