Although the amount of mortgage interest relief available to non-corporate landlords on residential property has been restricted since 2017 (firstly with a 3-year phased-in period, then fully since 6 April 2020), many landlords are reaching the end of low-interest rate fixed deals, and previously excluded Furnished Holiday Let (FHL) landlords are now being dragged into the regime. This restriction has once again become a very relevant issue for landlords of residential property.
The full force of the tax effect of the restrictions is about to become very real for many people, so it feels like a good time to revisit what it could mean for you.
How is rental income taxed?
First, it must be noted that the restriction applies to all finance costs related to residential property and not just mortgage interest. For most, though, it is the reduced relief on interest that has the biggest impact.
Under current legislation, when calculating taxable rental profits, interest and other finance costs must be ignored. Instead, the profit before this deduction is subject to income tax at normal rates, i.e., 20%, 40%, or 45%, depending on your total level of income. Once the tax has been calculated, a “tax reducer” of 20% of the interest/finance cost paid in the year is applied against the total tax due on the rental income.
Most people would assume that, for basic rate taxpayers, this would leave them in the same position. However, because of the way the calculation works, it can give surprising results, and even those who usually pay income tax at 20% have found themselves paying significantly more tax.
How does that work?
The best way to explain this is through a couple of examples:
- Basic Rate Tax-Payer pushed into higher rates
Let’s consider someone who has employment income of £40,000 per year and a single rental property with rental income of £20,000 before expenses. Let’s assume that they have other expenses of £5,000 and mortgage interest of £5,000.
Under the old rules, their taxable rental income would have been £10,000. This is then added to their employment income. The combined amount of £50,000 would be fully within the basic rate band, and they would have a £2,000 tax bill on the rental income.
Under the new rules, without a deduction for the interest paid, they will have taxable rental income of £15,000. Assuming that the higher rate tax threshold kicks in at current levels, £50,270, £4,730 of the rental income will now fall into the higher rate bracket.
Tax due on just their rental income will therefore be £3,946, before taking into account the tax reducer. Once we include the tax reducer of £5,000 x 20%, they are left with a final tax bill on their rental profits of £2,946 – some £946 higher than before.
On top of that, the increased deemed income may affect entitlement to child benefits or other means-tested credits.
- Heavily Geared Tax-Payers
Looking at a more extreme example, let us take someone who, after expenses but before interest, has £150,000 rental profits. They then pay £90,000 interest and have no other income sources.
Under the old rules, they would have £60,000 taxable income and have paid £11,432 tax on that (at current rates). However, because of the interest restriction, they are taxed on the full £150,000 first, before any relief for the interest.
As a result, not only do they pay tax at the higher rate of 40% on a substantial chunk of the rental income, but they are pushed into the 45% rate band for another sizeable slice. To add insult to injury, they lose the right to their personal allowances, which increases their tax burden further as they effectively pay 60% tax on part of the income.
After taking into account the 20% tax reducer, being £18,000 or 20% of £90,000, their tax liability comes to a whopping £41,742 – almost 4 times what they previously paid in tax.
Ignoring all other expenses, including any capital repayment element to the mortgage, this leaves them with a net cash profit of £18,258 – not much from a profit after the actual interest expense of £60,000!
The problem can be exacerbated further, and we have seen real-life examples when landlords who would once have been treated as having made a loss after mortgage interest in the past will now be deemed to have made a “profit” upon which tax is due.
Losses
Where losses are made before taking into account any interest, these will, of course, be lower than they previously might have been. They can continue to be carried forward, without taking into account the interest cost. Instead, unrelieved interest is separately accounted for and can also be carried forward for future relief at 20% as and when profits arise.
What can be done?
Pension contributions and Gift Aid payments will continue to provide some relief, but both of those will have an impact on your cash flow.
For most, this will not be enough to make the situation palatable. It is therefore no surprise that many landlords have sought to incorporate, which sadly does not come without costs (see my article on “Should I incorporate my Property Portfolio?” here). Others have simply sold up and got out of the market.
If you are considering either of the above, it is important that you take advice about your options so that you understand the potential tax implications.
Please contact the Gravita Tax Consultancy team here to discuss further.
