From 6 April 2017, income tax relief will gradually be reduced for interest payments made on loans taken out in the course of a residential property letting business.
The new rules apply to individuals, partnerships and limited liability partnerships. They also apply to interest on a loan taken out to acquire an interest in a property letting partnership. However, they do not apply to companies, even non-resident companies, except where the company carries on the letting business in a fiduciary or representative capacity.
Timetable for tax relief cuts
In 2017/18 one quarter of the interest paid will only attract tax relief at the basic rate of tax (currently 20%). By 2018/19 one half of the interest paid will be treated in this manner and three-quarters by 2019/20. From 2020/21 onwards, all interest paid by a landlord will attract relief at only 20%.
It is tempting to assume this change will only affect higher-rate taxpayers. Not so. The change can affect anyone whose gross rent (before interest) exceeds the basic rate band, even if they only receive net rent below the basic rate band. Even taxpayers who make no profit at all from their lettings may be subject to tax under the changes.
The new rules will not only apply to interest payments but also to premium, discount and returns under sharia-compliant arrangements, and to the incidental costs of obtaining the loan finance such as arrangement fees.
Companies and FHLs exempt
The change only applies to property letting businesses, not to property dealing or development, and not to the commercial letting of furnished holiday accommodation (FHLs). If a property is used for both residential and commercial letting, an apportionment must be done “on a just and reasonable basis” to calculate the amount of interest subject to the restriction.
The fact that the new rules do not apply to companies has not gone unnoticed. This was not an oversight. The corporation tax rate is only 20% (and is reducing) so the tax relief for interest payments by a company is already at this level. Nevertheless, there is now great interest in acquiring properties to be used for residential letting in companies. Likewise, the possibility of incorporating an existing property letting business is a hot topic.
Incorporation not a way out
Neither of these solutions is without its drawbacks. First, if the profits in a company have to be extracted, there will be a further tax charge at that stage. From April 2016, dividend income in excess of £5,000 will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers, and 38.1% for the additional rate taxpayers. Whether this produces a lower or higher overall tax bill than holding the property personally depends on the precise mix of rental income, interest payments and other expenses.
There are other ways of getting profits out of companies than paying a dividend, one of which is salary. However, salaries are subject to both income tax and national insurance contributions which may make them unattractive.
Secondly, if a property is held within a company, that gives rise to two potential tax charges on increases in value of the property – one when the property is sold by the company and one when the shares are sold (or the company wound up). This double charge has often made a company an unattractive wrapper for holding a property. That is even more so now that non-resident companies are subject to capital gains tax on sales of UK residential property.
Thirdly, there are capital gains’ complications on death in holding properties via companies. On the death of a shareholder there would be no re-basing of the property to its current market value so that a sale of the property (rather than the company) would attract capital gains tax.
Incorporation of an existing letting business has additional difficulties. There may be SDLT and/or capital gains tax to pay on the incorporation.
Bad news for landlords
All in all, the change is bad news for landlords. So bad, in fact, that some landlords have launched a legal challenge to the new rules, arguing that the new rules effectively grant unlawful state aid to corporate landlords, to whom, as mentioned above, the relief restriction does not apply. They also say the measure imposes an excessive and individual tax burden on private landlords, and thus violates their right to property under article 1 of the European Convention on Human Rights. This sounds a bold move. In a similar vein, the Government is now being intensively lobbied to abandon the proposals or to introduce exemptions.
Whether such actions will have any effect is not currently clear but taxpayers should probably plan on the changes being found to be legally effective and being implemented.