Tax changes for property landlords (buy to let) :

It was announced at summer Budget 2015 that tax relief available to landlords of residential properties for finance costs will be restricted to the basic rate of income tax. This will be phased in from April 2017 and will be fully in place from 6 April 2020. These rules are contained in  Finance (No. 2) Act 2015 as amended by Finance Bill 2016.

Tax year Percentage of finance costs deductible from rental income Percentage of basic rate tax reduction
2017/18 75% 25%
2018/19 50% 50%
2019/20 25% 75%
2020/21 0% 100%

All residential landlords with finance costs will be affected, but not all will pay more tax. In saying that, those landlords who are higher or additional rate taxpayers will be affected.

Finance costs will not be taken into account to work out taxable property profits. Instead, once the income tax on property profits and any other income sources has been assessed, the income tax liability will be reduced by a basic rate ‘tax reduction’.  For most landlords, this will be the basic rate value of the finance costs (see example below).

Who is affected?

  • UK resident individual that lets residential properties in the UK or overseas
  • Non UK resident individual that lets residential properties in the UK
  • Individual who lets such properties in partnership
  • Trustee or beneficiary of trusts liable for income tax on the property profits

Note that UK and non UK resident companies will not be affected and neither will landlords of furnished holiday lettings.

Restriction

The finance costs that will be restricted include interest on:

  • Mortgages
  • Loans – including loans to buy furnishings
  • Overdrafts

Other costs affected are:

  • Alternative finance returns
  • Fees and any other incidental costs for getting or repaying mortgages and loans
  • Discounts, premiums and disguised interest

If an individual takes out a loan for both residential and commercial properties, then he/she will need to use a reasonable apportionment of the interest to calculate finance costs for the residential properties (only the finance costs for the residential property business are restricted).

Published guidance

The guidance published by HMRC contains four case studies illustrating different scenarios. For the purposes of this article, we will consider case study three, which highlights the impact in the first year of the phased reduction.

The income tax rates and personal allowances for 2016/17 are assumed to remain unchanged for simplicity.

Case study three:

Jennifer has employment income of £25,000 and rental income from residential property of £11,000. Her mortgage interest is £8,000 per year and she has other allowable expenses of £500.The first tax year that finance costs will be reduced is 2017/18. This example shows the withdrawal of 25% of a finance cost deduction, which is then given as a basic rate tax reduction.

Jennifer’s total income (2017/18)

Earned income £ Rental income £ Total £
Income 25,000 11,000
Finance costs (£8,000 x 75%) (6,000)
Other allowable expenses (500)
Property profit 4,500
Total income 29,500

Jennifer’s income tax calculation (2017/18)

£ £
Total taxable income 29,500
Personal allowance (11,000)
18,500
Taxed at 20% 3,700
Less 25% of the finance costs (25% x £8,000) = £2,000 which gives rise to a basic rate reduction i.e. £2,000 x 20% (400)
Final income tax liability 3,300

Note that the reduction will be 20% of the lower of:

  • Finance costs not deducted from rental income in the tax year = £2,000
  • Property profits  (after using any brought forward losses) = £4,500
  • Adjusted total income (excluding savings and dividends income) that exceeds the personal allowance = £18,500

The lowest amount is finance costs, so £2,000 x 20% = £400 tax reduction

Summary

This forthcoming regime will no doubt lead to a great deal of head scratching for individuals especially in transitional years. Moreover, the reforms mean that the way taxable income is calculated will change. Consider the above example of Jennifer. Her taxable income in 2017/18 is £29,500, but a calculation under the current rules gives rise to a lower figure of £27,500. That increase in total taxable income may have wide-ranging implications for certain individuals.

For example, if an individual or partner receives child benefit and income is over £50,000, the high income child benefit charge may apply. Increased taxable income may push clients into a higher tax bracket, and could result in a restriction to the personal allowance where the £100,000 figure is breached. In addition, those individuals incurring chargeable event gains on insurance bond surrenders could be adversely affected.  As ever, the answer may well be pension contributions which are deductible in calculating adjust net income.

Further reading

https://www.gov.uk/guidance/changes-to-tax-relief-for-residential-landlords-how-its-worked-out-including-case-studies

 

Source: Prudential