21 Sep 2015
Author: Stephen Breen
The July budget introduced a cut in rental tax relief which is set to hit thousands of buy-to-let investors. The changes will be phased in from 2017 onwards and fully implemented by 2020. However, investors should take action now to ensure they are protected against the proposed cuts.
At present, buy-to-let investors can claim tax relief on the interest part of their mortgage repayments at the top rate of tax they pay. For higher rate tax payers, this means that for every £1 of finance cost they incur, they can pay 40p or 45p less tax. An interest payment of £100 only costs a landlord £55 after higher rate tax relief.
When the cuts are implemented in full, tax will be due on the full rental income less a 20% tax credit on the interest part of the mortgage payments.
Who will be affected?
Although it might seem that only higher rate tax payers will be affected, this is not necessarily the case. The complicated way that the cuts are being introduced will leave some basic rate payers far worse off after the changes have been made. Since basic-rate taxpayers will be perceived as having an increased income, this could push them into the higher-rate bands and affect entitlement to child benefit and tax credits.
For landlords paying the 40% tax rate with mortgage interest making up 75% of their rental income, investment firm Smith & Williamson have estimated that it will not be possible to make a profit from 2020. For those paying the 45% tax rate, it will not be possible to profit if mortgage interest makes up 68% or more of their rental income. If the mortgage interest is, say, 80% of their rental income, landlords will find themselves losing money.
The roll-out timetable
Currently landlords must pay income tax on income but can deduct expenses, which includes relief on the full amount of the interest part of their monthly mortgage payments.
Example: You rent a property for £10,000 per year and your mortgage interest costs you £6,000 per year. This means you pay tax on £4,000 at your usual rate (e.g. a basic rate tax payer would pay £800).
From 2017 landlords will be able to deduct 75% of their mortgage interest from their rental income. However, they will be able to claim 20% tax relief on the portion of interest that they could not offset against rental income.
In 2018, the amount will be reduced further to 50%.
In 2019, the amount will drop to 25%.
Finally, in 2020, you will need to pay tax on the full amount of rental income less a 20% tax credit on your mortgage interest.
Avoiding the tax blow
If you are looking to enter the buy-to-let market, setting up a limited company through which to make your investment is the best way to get round the problem. At this time there are no plans to prevent limited companies benefiting from relief on mortgage interest payments. Limited companies pay corporation tax at a rate of 20% on gains which will be cut to 18% from 2020.
Income from the company can be taken as dividends. Currently dividends are taxed at 0% (basic rate tax payer), 25% (higher rate tax payer) or 30.6% (highest rate tax payer), but these rate will rise next year to 7.5%, 32.5% and 38.1% respectively. The first £5,000 of any dividends paid will however be tax-free.
If you already own a buy-to-let property, seek advice before incorporating a company. Aside from the costs to set up and run the company itself, there may be stamp duty and capital gains tax to pay if you transfer ownership of an existing property to the new company. For buy-to-let landlords with a single property, it may not be worthwhile – but those with more than one property could still benefit.
There are other options if forming a limited company is not practical. Selling your property or increasing the rent could help to mitigate the additional tax due. You may also wish to consider converting the property to a furnished holiday let, where interest paid is not restricted. There are, however, conditions that must be met as to occupancy and periods of availability for the property to be considered under this regime. These include:
- There should be sufficient furniture provided for normal occupation and guests must be entitled to the use of furniture.
- The property must be available to let for 210 days each year.
- The property must actually be let out for 105 days each year.
- The property must not be let out to the same person for more than 31 days at a time.
If you are a buy-to-let landlord and would like advice on how to manage your property to reduce the impact of the pending tax changes, get in touch with our property team.