Sarah Bradford looks at the next phase of the changes to the way in which landlords receive tax relief for interest and the financial impact of the changes.
For tax years before 2017/18, obtaining tax relief for interest and financing costs was relatively straightforward – landlords simply deducted them in calculating their rental profits. The beauty of this system was that the landlord received the tax relief at his or her marginal rate of tax. For example, if a landlord incurred interest costs of £10,000 in a tax year, the tax relief, when given by deduction, was worth £2,000 to a basic rate taxpayer, £4,000 to a higher rate taxpayer, and £4,500 to an additional rate taxpayer.
However, this all changed from 2017/18 onwards, and the method of obtaining relief is gradually shifting from relief by deduction to relief as a basic rate tax reduction. The change is being phased in over four years and once fully implemented, all landlords running unincorporated property businesses will receive relief as a basic rate tax reduction. So, taking the case of a landlord with interest costs of £10,000 in a tax year, relief as a basic rate tax reduction will be worth 2,000 (i.e. £10,000 @ 20%), regardless of the rate at which the landlord pays tax. If the taxable profits of the business are less than the interest costs, the reduction is capped.
The rules apply equally regardless of whether the profits are calculated using the accruals basis or the cash basis. From 6 April 2017, the cash basis is the default basis for landlords running an unincorporated property business whose rental income for the tax year is £150,000 or less, and who meet the other cash basis eligibility tests.
Interest and finance costs
A landlord is allowed tax relief for interest on a loan up to the value of the property when it was first let. Interestingly, the mortgage or other borrowings do not need to be secured on the let property. For example, a landlord may decide to raise funds to purchase an investment property to let out by taking out a mortgage on his or her home. This can be effective where the landlord has sufficient capital in his home, as interest rates on residential mortgages are often lower than on buy-to-let mortgages.
Example 1: Increasing home mortgage to buy investment property
Abigail wishes to invest in a buy-to-let property. She finds a suitable investment property which costs £200,000. She pays a cash deposit of £20,000 and increases the mortgage on her own home from £50,000 to £180,000, to fund the balance of £180,000. She lets the property when the purchase is complete.
She pays interest on her mortgage at a rate of 3%.
She is able to obtain relief for interest on total borrowings of £200,000 (i.e. the value of the property when first let). This is an annual interest cost of £6,000 (i.e. £200,000 @ 3%).
The interest relief remains capped on borrowings of £200,000, even if the property increases in value while let.
Relief is also available for any incidental costs of obtaining the loan finance, as long as the interest itself qualifies for relief.
From deduction to tax reduction
The change in the way in which tax relief for interest is given to landlords is being phased in over four years – from 2017/18 to 2020/21. Each year, the proportion of interest for which relief is given by deduction decreases and the proportion for which relief is given as a basic rate tax reduction is correspondingly increased. This has the effect of moving from a position for 2016/17 and earlier tax years where relief for interest costs was wholly as a deduction in calculating the profits of the property rental business to one, from 2020/21 onwards, where relief is given in full as a basic rate tax reduction.
The change is phased in such that:
- in 2017/18, relief for 75% of the interest costs is given as a deduction, with relief for the remaining 25% given as a basic rate tax reduction;
- in 2018/19, relief for 50% of the interest costs is given as a deduction, with relief for the remaining 50% given as a basic rate tax deduction;
- in 2018/19, relief for 25% of the interest costs is given as a deduction, with relief for the remaining 75% given as a basic rate tax reduction; and
- in 2020/21 and later tax years, relief for 100% of the interest costs is given as a basic rate tax reduction.
Deduction v tax reduction
Relief by deduction is simple – the interest and other financing costs are simply deducted as for other expenses when calculating the profits of the property rental business.
The concept of relief as a basic rate tax reduction is slightly more complicated. Instead of deducting the interest when calculating the profit, the interest (or, in the transitional years, the proportion not eligible for relief by deduction) is ignored when working out the tax on the rental profits. The tax bill is then reduced by the basic rate tax reduction, which in most cases is 20% (being the basic rate of tax) of the interest costs. So, if the interest costs are £5,000, the tax bill (calculated without taking account of interest) is reduced by £1,000.
If the profit is less than the interest costs or the profit is sheltered by the personal allowance, the basic rate reduction is capped, and is 20% of the lower of:
- finance costs not deducted in the tax year;
- profits of the business for the tax year; and
- total income that exceeds the personal allowance for the year.
This prevents the tax reduction generating a tax repayment – at best, it can reduce the tax bill to nil if the taxpayer is a basic rate taxpayer. Any unrelieved interest costs can be carried forward to the following year.
Example 2: Unrelieved interest costs carried forward
In 2017/18, Gabby has rental income of £10,000. She incurs interest costs of £8,000, of which £6,000 (75%) are relieved by deduction, and other expenses of £3,000. Before giving relief for the remainder of her interest costs of £2,000, her rental profit is £1,000 (£10,000 – (£6,000 + £3,000). If she is a higher rate taxpayer, the tax before the tax reduction is £400 (£1,000 @ 40%).
As her profits of £1,000 are less than the unrelieved interest of £2,000, the basic rate tax reduction is worked out on the profit figure of £1,000; a reduction of £200 (£1,000 @ 20%). Her tax bill is reduced to £200 and the unrelieved interest costs of £1,000 are carried forward to 2018/19.
Impact of the shift
For 2017/18, the split is 75:25 in favour of deduction; for 2018/19, this moved to 50:50. This means that if a landlord pays tax at a rate above the basic rate, he or she will pay more tax in 2018/19 than in 2017/18, even if everything else stays the same.
Example 3: Retained profits compared
Roger has two investment property that he lets out. He also works in IT, earning a salary of £50,000. He pays tax on his rental profits at 40%.
In 2017/18 and 2018/19, his rental income is £25,000. He has interest costs of £10,000 and other expenses of £3,000.
In 2017/18, he can deduct £7,500 (75% of £10,000) in calculating his rental profit. Relief for the remaining £2,500 is given as basic rate tax reduction of £500 (£2,500 @ 20%).
In 2018/19, he can deduct £5,000 (50% of £10,000) in calculating his rental profit. Relief for the remaining £5,000 is given as a basic rate tax reduction of £1,000 (£5,000 @ 20%).
The tax payable for each year is calculated as follows:
£ £ £ £
Rental income 25,000 25,000
Expenses (3,000) (3,000)
Interest deduction (7,500) (5,000)
Taxable rental profit 14,500 17,000
Tax @ 40% 5,800 6,800
Basic rate tax reduction ( 500) (1,000)
Tax ( 5,300) (5,800)
The profits retained by Roger for each year are as follows:
Rental income 25,000 25,000
Interest costs (10,000) (10,000)
Other expenses ( 3,000) ( 3,000)
Tax ( 5,300) ( 5,800)
RETAINED 6,700 6,200
As a result of the shift, Roger gets to keep £500 less of his rental income in 2018/19 than in 2017/18, despite the fact that nothing has changed.
Landlords should make sure they understand and apply the new rules when working out the tax due on their rental income for 2017/18 onwards.
This article was first printed in Property Tax Insider in May 2018.