An estimated 1 in 30 adults in the UK are landlords. But new rules on tax relief mean that net income from private rental properties could be reduced by tens of thousands of pounds per year. The new rules are particularly complex for trustees and executors.

The good news is that there may be steps that can be taken to reduce exposure.

Adrian Moss and James Amico of Penningtons Manches’ private client team explain:

Background

Prior to 6 April 2017, the calculation of rental income was relatively simple, ie the gross rent received during the tax year, less any expenses wholly and exclusively incurred in relation to the letting of a rental property – this could include utility bills, repair costs and often most prominently mortgage interest.

From 6 April 2017, the ’finance expenses’ deductible in calculating the taxable rents received have been restricted. Finance expenses will most commonly relate to the mortgage interest a landlord pays but can also include interest payments on loans which have been obtained to furnish the property, overdraft fees, banking fees, etc.

Who is impacted?

These restrictions will apply to all landlords of a residential property. These landlords can either be individuals, trustees or executors. The restrictions will not apply to companies, commercial lets or furnished holiday lets.

What are the restrictions?

Prior to 6 April 2017, finance expenses were wholly deductible in calculating the taxable income for the year. It is intended that by the year ended 5 April 2021, no finance expenses will be deductible in calculating the taxable rents. Instead a tax credit at the basic rate will be applied to the resulting income tax payable.

To give landlords time to adjust to these new measures (and also to ensure their rental position is still viable), these restrictions are being introduced over a number of tax years as follows:

Tax year ended Proportion of financial expenditure deductible Proportion of financial expenditure qualifying for a basic rate tax credit (currently 20%)
5 April 2017 (or earlier) 100% 0%
5 April 2018 75% 25%
5 April 2019 50% 50%
5 April 2020 25% 75%
5 April 2021(or later) 0% 100%

What is the impact of the restrictions?

The extent of finance expenses (both immediately and in the future) is the main factor in assessing the impact of the changes. Furthermore the impact will largely depend on the taxpayer’s overall levels of income before and after rental property income is considered.

It is important for landlords to assess their hypothetical income tax position to understand the impact and to what extent the mitigation steps described below may be worthwhile.

Example one

The taxpayer owns two residential buy-to-let properties which are their main source of income. In addition to this, they earn an annual salary amounting to the personal allowance each year.

Prior to the introduction of these changes the taxpayer is only subject to income tax at the basic rate, making a net tax profit of £24,000. As the restriction of financial expenses takes effect, the taxpayer’s net rental income increases resulting in them being subject to income tax at the higher rates.

By 2020/2021 the taxpayer will be subject to an additional £7,100 of income tax. The introduction of the deductible basic rate tax credit will not fully account for this increase and as a result the taxpayer’s net income for the year will reduce by 13% to £20,900.

Tax year ended 5 April 2017 2018 2019 2020 2021
£ £ £ £ £
Other income 11,000 11,500 11,850 11,850 11,850
Rental income 50,000 50,000 50,000 50,000 50,000
Loan interest (20,000) (15,000) (10,000) (5,000) Nil
Net rental income 30,000 35,000 40,000 45,000 50,000
Less:
Personal allowance (11,000) (11,500) (11,850) (11,850) (11,850)
Taxable income 30,000 35,000 40,000 45,000 50,000
Tax payable 6,000 7,300 9,100 11,100 13,100
Tax credit for finance exp Nil (1,000) (2,000) (3,000) (4,000)
Total income tax payable 6,000 6,300 7,100 8,100 9,100
Net profit after tax 24,000 23,700 22,900 21,900 20,900

Example two

The taxpayer owns a large property portfolio holding 60 properties with circa 50% gearing. Due to the high income levels, the taxpayer’s personal allowance is fully abated.

Similar to the example above, the restriction of financial expenses results in the taxpayer’s taxable income increasing by £125,000. By 2020/21 the resulting increase in income tax reduces the taxpayer’s net income by 11% or £25,750 per year.

Tax year ended 5 April 2017 2018 2019 2020 2021
£ £ £ £ £
Rental income 525,000 525,000 525,000 525,000 525,000
Loan interest (105,000) (78,750) (52,500) (26,250) Nil
Net rental income 420,000 446,250 472,500 498,750 525,000
Less:
Personal allowance Nil Nil Nil Nil Nil
Taxable income 420,000 446,250 472,500 498,750 525,000
Tax payable 175,100 186,613 198,225 210,038 221,850
Tax credit for finance exp Nil (5,250) (10,500) (15,750) (21,000)
Total income tax payable 175,100 181,363 187,725 194,288 200,850
Net profit after tax 244,900 238,638 232,275 225,713 219,150

How are trusts affected by the changes?

The operation of the restriction for trusts is complex and depends on the terms of the trust. For discretionary trusts, the basic rate tax deduction is allowable in a similar manner to individual owners. However, with life interest or interest in possession type trusts, the basic rate deduction is not allowed and there is a mechanism to pass the possible basic rate deduction to the beneficiary to use in their personal tax return. There can be quite adverse outcomes in applying this mechanism and it is recommended that trustees of life interest trusts with residential property finance costs seek expert advice.

How can I reduce the impact of the restrictions?

Landlords are considering a number of possible steps to mitigate the tax impact of the changes and many are considering an overall tax and succession plan.

  • Gifts of property 

A simple and cost effective way of reducing the impact of the above is gifting parts or the entire property to an individual who is subject to a lower rate of income tax than the current recipient. This often takes place between spouses as they will be able to transfer shares in the residential property without generating a disposal for capital gains tax (CGT) purposes. Care should be taken to assess any impact with mortgage providers or any impact caused by the assumption of another party of mortgage debt – which would be treated as an acquisition for stamp duty land tax (SDLT) purposes. The costs and benefits of this approach will need to be considered carefully. The implementation of this strategy must also be dealt with carefully as where spouses hold a property in unequal shares and they intend to tax the rents received in accordance with these ownership interests, a declaration must be made to HM Revenue & Customs to give this tax effect.

  • Finance cost reduction 

Many landlords are reducing gearing in their property portfolio by selling properties and repaying mortgages to reduce their finance costs. Whilst this may have a positive tax impact, there will likely be a loss in profitability of the rental business overall.

  • Incorporating 

A company is not subject to the same restriction on finance costs and many landlords are considering the implications of incorporating their rental property portfolio. Of added impetus to landlords considering this step is the historically low corporation tax rate that currently applies (20% and due to drop to 17% in 2020).

On the face of it, the possibility of both CGT on a deemed disposal of properties into a company and SDLT on a deemed acquisition at market value by the company, the entry costs can seem prohibitive.

However, where there is sufficient business activity (time involvement) in the rental property business, ’incorporation relief’ should be available on incorporation of property portfolio, so long as it is transferred in its entirety. Incorporation relief, to the extent that it is chosen to apply, reduces the CGT to £0.

Furthermore, some property businesses which are operated in ‘partnership’ – broadly with co-owners sharing a view to profit – may also benefit from a less well known reduction in SDLT (to 0%) on the incorporation of the rental property business.

When other planning factors, such as succession arrangements and the introduction of loans at the outset, are considered, incorporation of the property business can be a very compelling option.