Whilst tax relief on loans for private purposes is basically forbidden by the tax rules, there are ways to secure a deduction, if you can demonstrate that your finance costs are supporting a business. This article looks at the rules for this valuable relief, and the next article will look at how the new regime for residential mortgages is expected to affect the relief in future. Please note that this guidance is meant for landlords who are individuals; the rules for finance costs in companies are quite different, although there is some overlap.
Fundamentally, if you borrow money to finance a trading or property business, you should get tax relief on any interest incurred. However, borrowing to finance private expenditure is not allowed, in principle. The underlying question is: from a tax perspective, what was the purpose of the borrowing? The answer may not be as straightforward as you think.
Example 1 - Starting a buy-to-let property business
Jack owns his own home (with a mortgage). He decides to start a buy-to-let business, and buys his first rental property, which is worth £230,000. He uses cash savings for the deposit of £30,000 and borrows the remaining £200,000. Can he claim mortgage interest on that borrowing?
Yes, of course: he has introduced an asset to his brand new property business venture, worth £230,000 and subject to a mortgage of £200,000. The property effectively ‘owes’ him £230,000 for the asset, which the business is using to generate rental income, against which the business is notionally also carrying a debt of £200,000. The interest is clearly a cost of the rental business. See also HMRC’s Property Income manual at PIM2105.
Example 2 - Increasing a mortgage on the home
What if Jack doesn’t have the cash savings but borrows the extra £30,000 for the deposit by extending the mortgage on his own home?
It doesn’t matter what the borrowings are secured on - it matters what the borrowings are for. Essentially, if the business owes Jack because the value of the asset(s) he’s introduced were worth at least the aggregate borrowings the business is also funding, then he should get tax relief (see HMRC’s Business Income manual at BIM45685).
In this case, the borrowings equate to the value of the asset introduced, which is OK. Borrowings in excess of the value introduced will not be ‘allowed’; the proportion of interest corresponding to any private excess would be disallowed (see also BIM45695, which confirms that interest costs on a single account may be split between the private proportion and the business element, which can be claimed for tax purposes).
Example 3 - Unallowable borrowing
Let’s say that, a couple of years after Example 2, the rental property is now worth £275,000. Jack therefore has £45,000 of equity in his investment property. He wants to extend his own home, but he has maximised the available borrowing in his own home to put down the £30,000 on his first rental property. He therefore decides to extend the borrowing on his rental property by a further £25,000 to help fund the extension on his home. Will he get tax relief on the increase in his rental property mortgage interest?
No, because the rental business is already funding the entire value of the rental business asset when it was first introduced to the rental business.
When the business started two years ago, the rental property was worth £230,000 and was funded by a £200,000 mortgage on the property itself, and a £30,000 extension on Jack’s home mortgage.
The corresponding interest charge on both parts may be claimed in full, but even though the business asset is now worth significantly more than £230,000, HMRC would seek to disallow the interest on any additional borrowings that would take the total business borrowing beyond that initial £230,000.
Example 4 - Buying a second rental property
What if Jack were instead to release the fresh equity on the rental property to put down £20,000 on a further investment property, worth £250,000? Let’s say that Jack’s second mortgage is £220,000, with £10,000 coming from cash savings.
This would be fine, because Jack would be introducing a further capital asset to the rental business worth £250,000 – more than the extra borrowing.
So, in Example 4:
Rental property 1 - Value on Introduction: 230,000
Rental property 2 - Value on Introduction: 250,000
Total capital introduced to the property business: 480,000
Finance claimed in the rental business:
Mortgage against rental property 1 200,000
Increased mortgage on Jack’s home for rental property 1 30,000
Increased mortgage on rental property 1 now (for rental property 2) 20,000
Mortgage on rental property 2 220,000
Total finance supported by property business: 470,000
While the first rental property was 100% financed by borrowing, Jack has used £10,000 of cash to help to fund the acquisition of the second property, which is why the total borrowings are a little less than the total asset values on introduction.
In theory, then, Jack can borrow up to a further £10,000 from his rental business, and still get tax relief for that borrowing. What if, a year later, he borrows a further £10,000 secured on his second rental property, to go on a family holiday?
What is the borrowing ‘for’?
The obvious response is to say that the borrowings are clearly for private purposes, so the interest on the additional loan cannot be allowed from a tax perspective. This analysis would be shared by many tax inspectors, were it not for BIM45700 (although it should be noted that HMRC’s guidance is not legally binding), which concentrates instead on the fact that the borrowing has allowed the landlord to finance the introduction of income-generating assets, so is effectively for business purposes:
‘A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business. There will, though, be an interest restriction if the proprietor’s capital account becomes overdrawn...’ (emphasis added).
Note that, in the examples given at BIM45700, it is clear that the fact that the funds may be withdrawn for private enjoyment is not relevant, so long as the simple arithmetic in Example 4 is followed, and the total borrowings do not exceed the value of capital assets initially introduced to the business.
The above examples should help to demonstrate that, while it may be counter-intuitive to think that extracting capital from your property business to fund private activities will be allowable, the correct test for tax purposes is whether or not you have ‘put in’ more than you have ‘taken out’. So long as you have not withdrawn too much capital, then the finance cost of business borrowing should be allowable.
The second article will look at how this useful relief will fare when the new interest restriction rules for residential lettings start to bite, in April 2017.
This article was first printed in Property Tax Insider in April 2016.