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The New Mortgage Finance Restrictions: From Bad to Worse?

Shared from Tax Insider: The New Mortgage Finance Restrictions: From Bad to Worse?
By Lee Sharpe, April 2016
Lee Sharpe warns that the new rules restricting tax relief for residential letting mortgages will mean that some landlords will not effectively even get 20% tax relief.

We have been warning for some months now that residential property landlords are facing some deep cuts to one of their most important tax reliefs – mortgage interest and similar payments. When I reviewed the draft legislation earlier this year, I noted several scenarios where there seemed to be a real risk that the cost to landlords would be worse than expected. The key points are set out below. 

To assist in understanding the risks, it is important to set out the basic principles for how the disallowance will work. The new regime is to be introduced in four equal phases from 2017/18 – a little over a year away now.

Step 1
Disallow the mortgage interest claimed (in progressively larger 25% proportions, from 2017/18 through to 2020/21 and onwards)

Step 2
Grant a tax credit that is at first equal to 20% of the relief disallowed in Step 1. 

Unfortunately, there are numerous conditions and restrictions to Step 2. 

Only certain incomes ‘count’
The new rules will permit the 20% tax credit only to the extent that sufficient tax has already been paid on the ‘right kinds’ of income. Tax on dividends and savings income does not count; nor any disallowed interest element which is less than the taxpayer’s tax-free personal allowance (a form of carry-forward is permitted – but see later). I conclude that the government’s point is that, if you have funds that are generating interest or dividends, you should be using them to pay off your BTL mortgages. 

Example 1 – Bill the basic rate taxpaying employee

Bill works full-time and has a salary of £35,000. He also has a single investment property which generates £3,000 of net rental income, after £3,000 of mortgage interest. (All examples in this article will work with 2020/21 figures, when the new regime is 100% installed. We shall assume that the tax-free personal allowance has risen to £12,000, and the higher rate threshold ‘kicks in’ at £45,000). 

In the above example, Bill has stayed below the higher rate threshold, so the additional tax due on his disallowed mortgage interest has been balanced by the corresponding 20% tax credit.
£      £
Salary 35,000
Property profit (after mortgage interest)   3,000
Mortgage interest 3,000
Total income 38,000
Total income for tax purposes
Add back mortgage interest @ 100% (2020/21)   3,000
Chargeable  41,000
Less: Personal allowance  12,000
Taxable  29,000
Taxed at 20%    5,800
Less: Mortgage interest tax credit (£3,000@20%)   600
Total tax due    5,200


Example 2 – Brenda the company director shareholder

Brenda is a director and shareholder in her own company. She traditionally takes a modest salary of around £10,000 topped up with around £30,000 (net) of dividend income. On top of that, Brenda has a single mortgaged residential property which she lets out. 

Her 2020/21 financials break down as follows:
£ £
Salary        8,000
Dividend (net = gross from 2016/17)       30,000
Property profit (after mortgage interest)         3,000
Mortgage interest       3,000
Total income       41,000
Total income for tax purposes
Add back mortgage interest @ 100% (2020/21) 3,000
Chargeable        44,000
Less: Personal allowance                12,000
Taxable 32,000
£2,000 at 20% on disallowed mortgage interest   400
£30,000 at 7.5% on dividends*   2,250
  2,650
Less: Mortgage interest tax credit (£2,000 @ 20%)              400
Total tax due   2,250

*The new ‘dividend nil rate’ (ITA 2007, s 13A to be) has been ignored for simplicity.

In Example 2, the disallowed interest is £3,000, but Brenda gets only £2,000 @ 20% in corresponding tax credit, because the first £1,000 falls within her tax-free personal allowance (dividends ‘float’ above earnings and rental income, so the first £1,000 of disallowed interest is used up in her tax-free allowance). 

Now, to an extent, it is fine that the rental interest tax credit does no more than offset the additional rental income that is deemed taxable. But the knock-on effect is to increase the amount of dividend income which is taxed because, without the disallowed interest, some dividend income would also have escaped tax by falling in the last £1,000 of the tax-free allowance. This is the effect of the new ITTOIA 2005, s 274A(4) and the restriction of credit by reference to the surplus over ‘adjusted total income’ – above the personal allowance. A form of carry-forward of the £1,000 in unused relief is available, thanks to s 274A(5).

Knock-on effects
In fact, there are numerous adverse consequences to the new disallowance:

  • Potentially the most serious is being ‘pushed’ into higher rates of tax simply by reason of the disallowance, so that the 20% credit is insufficient, despite the true economic profit (i.e. net of mortgage interest) being comparatively modest.
  • The disallowance may also ‘push’ other income into higher rates of tax, as above – or, at high income levels, the taxpayer may start to lose his or her personal allowance (basically where income exceeds £100,000) as a result. 
  • Student loan repayments are based on an assessment of chargeable (i.e. tax-adjusted) income (by reason of SI 2009/470, Reg. 29(4)), so the disallowance may well trigger higher loan repayments.
  • The clawback of child benefit receipts likewise depends on the level of adjusted income (again, essentially tax-adjusted income, albeit adjusted a little differently) by reason of ITEPA 2003, s 681B et seq.
  • Being forced into higher rates of tax will bar married couples from being able to transfer a part of their tax-free personal allowance (under the new ITA 2007, s 55A et seq.).
  • The new tax-assisted childcare regime (when it eventually arrives) will likewise be unavailable to a family if one or more parent’s income exceeds £100,000.
  • At lower levels of income, there are likely also to be adverse effects on entitlement to tax credits, (see SI 2002/2006, Reg. 11(1)) and other benefits which are means-tested against income. 

Unforeseen consequences?
Perhaps readers may, cynically, conclude that the Treasury is not unduly concerned if its new regulations mean that landlords pay more tax than expected by dint of the above. But it is possible for the additional amounts due in respect of student loans, child benefit clawback, etc. to exceed the extra tax itself, which seems more than a little perverse.

Devil in the detail
When the amount of tax credit given is less than 20% of the disallowed interest, the unutilised relievable amount may be carried forward. The legislation ties itself up in knots trying to make this work. Succinctly, it fails, to the taxpayer’s detriment. The legislation aims to preserve unused 20% credits for carry forward for use in later years. But the new legislation does not cater well for conventional property losses and, where:

  • conventional rental losses are brought forward; and 
  • the landlord has little/no income other than rental income, so the tax-free personal allowance is not otherwise used.

There is plenty of scope to waste tax relief. The key point is that the ‘safety valve’ in the legislation, namely the new ITTOIA 2005, s 274A(4), (5), is faulty, because ‘adjusted total income’, as defined, ignores rental losses brought forward. 

This is a point I raised with HMRC in September, but although it has been acknowledged, the legislation has not been adjusted. 

Practical Tip:
The legislation dealing with the interest disallowance and the corresponding tax credit is some of the most difficult I have ever come across. Tax should not need to be so taxing. I understand that some landlords have banded together to mount a legal challenge and to try to get the legislation overturned. On the one hand, I have invested a very substantial amount of time to understand and advise on the effects of the new regime. On the other, I should not regret a minute if they were successful. 
Lee Sharpe warns that the new rules restricting tax relief for residential letting mortgages will mean that some landlords will not effectively even get 20% tax relief.

We have been warning for some months now that residential property landlords are facing some deep cuts to one of their most important tax reliefs – mortgage interest and similar payments. When I reviewed the draft legislation earlier this year, I noted several scenarios where there seemed to be a real risk that the cost to landlords would be worse than expected. The key points are set out below. 

To assist in understanding the risks, it is important to set out the basic principles for how the disallowance will work. The new regime is to be introduced in four equal phases from 2017/18 – a little over a year away now.

Step 1
Disallow the mortgage interest claimed (in progressively larger 25% proportions,
... Shared from Tax Insider: The New Mortgage Finance Restrictions: From Bad to Worse?