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Restricting tax relief on mortgage interest for rental profits

 

Background

On 6th April 2017, the government introduced new rules which mean buy-to-let investors can no longer offset all their mortgage interest costs against rental income before calculating their tax liability.  The new rules only apply to individuals (sole traders and partnerships) - limited companies that hold buy-to-let properties are not affected.

By 2020,  no finance costs (normally mortgage interest) will be tax-deductible. The changes mean that many individuals with buy-to-let properties will pay more tax - even if they saw no increase in their income.  The new rules started being phased in from 6th April 2017 and will be fully in place from 6th April 2020.

This represents a significant change in the government’s approach. Prior to 6th April 2017, landlords could deduct all mortgage interest, finance costs, and other allowable expenses from their rental income before calculating their tax liability. If the landlord was a higher rate taxpayer, they received 40% tax relief on net income from their buy to let properties. Additional rate taxpayers received relief at 45% on their net income.

What is included in finance costs?

The finance cost restriction will affect mortgages, loans, (including loans to buy furnishings) and overdrafts. Other costs affected include alternative finance returns
fees, any other incidental costs for securing or repaying mortgages, and loans
Discounts, and premiums.


Loans for combined residential and commercial properties will need to be reasonably apportioned to establish the residential element (the commercial element is exempt from the new rules).

Who will be affected?

All individuals, both in the UK  and overseas, who own and gain income from buy-to-let residential properties in the UK, will be affected. Even if letting through a partnership, trustee or beneficiary of trusts. As long as there is a mortgage interest or finance cost you are looking to secure tax relief on, you’ll be affected.

These rules don’t apply to landlords of furnished holiday lettings, and UK and non-UK resident companies who will continue to receive relief for interest and other finance costs in the usual way.

How is it being phased in?

The following table shows the impact of the phasing in of the new rules between 2017 and 2020,  with the percentage of finance costs deductible reducing while the basic rate tax reduction increases.

Tax year

Percentage of finance costs

deductible from rental income

Percentage of finance costs

at  basic rate tax

reduction

2017/18

75%

25%

2018/19

50%

50%

2019/20

25%

75%

2020/21

0%

100%

The following examples show the impact of the new rules on the income of a higher rate taxpayer.

Example 1 - Partial tax relief

In 2017/18, an individual has buy-to-let property income of £20,000 and their only rental expense is mortgage interest, which amounts to £10,000. They are also a higher rate tax payer.

Property rental income

£20,000

Less: Mortgage interest x deductible finance cost percentage (75% of £10,000)

(£7,500)

Property rental profits (£20,000 - £7,500)

£12,500

Tax @ 40% (40% of £12,500)

£5,000

Mortgage interest x basic rate reduction percentage (25% of £10,000)

£2,500

Basic rate tax relief (20% of £2,500)

£500

Total tax due (£5,000 - £500)

£4,500

 

Example 2 - Full restriction of mortgage relief

In 2020/21, an individual has buy-to-let property income of £20,000 and their only rental expense is mortgage interest of £10,000. They are a higher rate tax payer.

Property rental income

£20,000

Less: Mortgage interest x deductible finance cost percentage (£10,000 x 0)

(£0)

Property rental profits (£20,000 - £0)

£20,000

Tax @ 40% (40% of £20,000)

£8,000

Mortgage interest x basic rate reduction percentage (100% of £10,000)

£10,000

Basic rate tax relief (20% of £10,000)

£2,000

Total tax due (£8,000 - £2,000)

£6,000

Further implications of the restriction

As shown above, every mortgaged landlord who pays 40% or 45% rates will pay more in tax, but so will some basic-rate taxpayers as they are pushed into the higher-rate tax bracket. This has significant implications for other income sources such as child benefit which may also become taxable if income exceeds £50,000.

What happens if my finance costs are higher than rental profits or total income?

The new restriction applies to all types of finance costs (normally mortgage interest). However, you only get basic rate relief (currently 20%) on total finance costs, where these are higher than total rental profits or total earned income.

If the basic rate tax reduction is calculated using the ‘rental profits’ or ‘total earned income’ then the difference between that figure and ‘finance costs’ is carried forward to calculate the basic rate tax reduction in the following years.

Tax reduction can't be used to create a tax refund.

Example 3 - Rental profits higher than finance costs

In 2020/21, an individual has buy-to-let property income of £10,000 and their only rental expense is mortgage interest of £20,000. They are a higher rate tax payer.

Property rental income

£10,000

Less: Mortgage interest x deductible finance cost percentage (£20,000 x 0)

(£0)

Property rental profits (£10,000 -£0)

£10,000

Tax @ 40% (40% of £10,000)

£4,000

Mortgage interest (limited to £10,000 rental profits) x basic rate reduction percentage (100% of £10,000)

£10,000

Basic rate tax relief (20% of £10,000)

£2,000

Total tax due (£4,000 - £2,000)

£2,000

Finance costs carried forward (£20,000 - £10,000)

£10,000

You’ll still be able to deduct some of your finance costs when you work out your taxable property profits during the transitional period per the table above, but these deductions will be gradually withdrawn and replaced with a basic rate relief tax reduction.

 
 
Last Updated: 26 Jul 2017 08:55AM BST

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