There are far reaching and fundamental changes to the way rental property income is to be taxed which may come as a nasty shock to many landlords.
Whilst commercial properties and furnished holiday lettings are not affected by the proposals, last years changes to stamp duty caught many borrowers out when they came to completion and learned of significant stamp duty charges they had not been informed of.
More complications are unfolding and landlords need to consider tax planning as part of any purchase or remortgage.
None of the following should be considered as advice – this is provided as an illustration of the issues some landlords may face.
Restriction of tax relief on interest
From 6th April 2017, tax relief on interest paid by landlords of residential properties will be restricted gradually by 1/4 for each tax year.
From 6th April 2020, interest will no longer be an allowable expense in computing the profits of the business. Instead mortgage interest will attract tax relief at 20%.
Fred is a 40% taxpayer. He wants to purchase a buy to let property and intends to obtain a £100,000 mortgage. Here is the effect of the change:
|Repairs & other tax deductible costs||975||975|
|Interest on mortgage||3,600||–|
|Net rental profit||3,525||7,125|
|Tax at 40%||1,410||2,850|
|Less interest relief at 20% on £2,500||500|
|Net tax liability on rental income||1,410||2,350|
|Tax increase per year||940|
More concerning a basic rate (20%) taxpayer may also be affected by the changes as the rental income before mortgage interest may take them into the higher rate of tax.
Example 1 – How a basic rate tax payer may be affected
Take the case of Harry. Harry has a salary of £11,000. He owns a number of rental properties on which his profit is £32,000 after deducting mortgage interest of £36,000.
See how the changes will affect Harry.
|£32,000 @ 20%||6400||6400|
|£36,000 @ 40%||–||£14,400|
|Mortgage interest relief is £36,000 @ 20%||–||(7200)|
|Effective rate of tax on net income||20%||42.25%|
Highly geared taxpayers may find the tax liability is more than the net rental income after paying the interest. This clearly might lead to financial difficulties for those individuals.
Removal of the 10% wear and tear allowance for furnished lettings
From 6th April 2016 the 10% wear and tear allowance on fully furnished properties will not be available. It is due to be replaced by a new Replacement Furniture Relief. This means that expenditure on replacing items of furniture and white goods will be allowed but if new items are added then they will not be allowed on the initial purchase.
So what can landlords do?
Following qualified tax advice landlords may choose to consider:
Example 2 – ownership transfer to a lower earning spouse.
Transfer of equity / ownership between spouses is a tax neutral possibility although stamp duty may apply if the amount being transferred exceeds £40,000.
HMRC requires notice of this having taken place within 60 days if following the transfer the property is held in any ratio other than 50 : 50. Otherwise HMRC will not recognise the transfer until the notification is filed.
Example 3 – ownership transfer to a limited company (or acquisitions by a limited company)
Following qualified tax advice this may be an option for some landlords based on:
100% tax relief being available on the mortgage interest.
Up to £5,000 profit available as a tax free dividend. This could increase to £10,000 if the company is set up with 2 shareholders i.e. husband and wife.
Surplus profits can be used to pay off debt, acquire further properties or fund a pension plan.
Transfer of the properties from individual ownership to a limited company can be done without incurring capital gains tax using section 162 TCGA 1992 relief. This is subject to the qualifying criteria being met. Advice from a qualified tax specialist is essential.
Typical drawbacks include:
On the sale of a property the company pays corporation tax on any gain after indexation relief. Withdrawing the sale proceeds could be problematic if all the sale proceeds pushes the income into the higher rate band of 40%. Currently the top rate of capital gains tax paid by an individual is 28%.
Transferring existing properties may give rise to a capital gains tax liability as well as a stamp duty charge. Careful planning needs to be given to establish the one off costs of transfer compared to the annual tax increase.
Example 4 – use of property to be classed as commercial or a furnished holiday let
The changes do not apply to commercial property or furnished holiday lettings.
All the above options come with advantages and disadvantages as well as pitfalls, so taking advice is imperative before borrowers take any action.
If you have a tax expert who is familiar with your property investments we recommend you speak to them.
If you don’t know an expert or need further advice you can request a Free 15 minute consultation with a property tax specialist. Click here for more information.