Landlord Tax Changes – Restriction on Mortgage Interest Relief

Landlord – interest relief restriction: deduction v tax reduction

In his July 2015 Budget, the Chancellor dealt a blow to landlords with his announcement that from April 2017 relief for finance costs would be progressively restricted. In giving effect to the restriction, landlords would move from the current position where they are able to deduct finance costs, such as mortgage interest, in full when computing their rental profits, to one where relief is given as a basic rate tax reduction.

Phased in

The switch from deduction to interest rate reduction is to be phased in over four years, with a gradual shift away from deducting property finance costs from property income.

Tax year

% finance cost relievable by deduction

% finance costs given as basic rate tax reduction

2017/18

75%

25%

2018/19

50%

50%

2019/20

25%

75%

2020/21 onwards

0%

100%

 

Deduction v basic rate tax reduction

Where relief is given by deduction, the landlord obtains tax relief at his marginal rate of tax. The property finance costs are deducted in arriving at the taxable profit and that profit is taxed at the landlord’s marginal rate of tax.

By contrast, where relief is given as a tax reduction, the rental profit is first calculated without taking account of the finance costs relieved by tax deduction and the tax is worked out on those profits. Effect is given to the basic rate tax reduction by deducting an amount equal to the finance costs x the basic rate of tax from the tax figure initially computed on the profits.

Example

Ian is a landlord. In each year from 2016/17 to 2020/21 inclusive, he has property income of £30,000. He pays mortgage interest costs of £6000 and incurs other expenses of £2000. He also has a salary of £60,000 and pays tax on his property income at the higher rate of 40%.

His tax position for each of the years is as follows:

2016/17

2017/18

2018/19

2019/20

2020/21

£

£

£

£

£

Property income

30,000

30,000

30,000

30,000

30,000

Expenses

(2000)

(2000)

(2000)

(2000)

(2000)

Deductible finance costs

(6000)

(4,500)

(3,000)

(1,500)

nil

Taxable profit

22,000

23,500

25,000

26,500

28,000

Tax on profit (@40%)

8,800

9,400

10,000

10,600

11,200

Tax reduction @ 20%

0

(300)

(600)

(900)

(1200)

Total tax

8,800

9,100

9,400

9,700

10,000

 

Summary

2016/17

2017/18 2018/19 2019/20 2020/21

£

£

£

£

£

Property income

30,000

30,000

30,000

30,000

30,000

Expenses

(2000)

(2000)

(2000)

(2000)

(2000)

Finance costs

(6000)

(6000)

(6,000)

(6,000)

(6,000)

Tax

(8,800)

(9,100)

(9,400)

(9,700)

(10,000)

Profit retained

13,200 12,900 12,600 12,300

12,000

 

As a result of the shift from relief by deduction for 100% of property finance costs to relief by basic rate reduction for 100% of finance costs, Ian’s retained profit is reduced by £1,200.

Sting in the tail

Moving from deduction to tax reduction has hidden costs. The relief is given later in the calculation, which has the effect of increasing the taxpayer’s taxable income. This may move him into a higher tax bracket or trigger the high income child benefit charge or the abatement of the personal allowance.

Those most likely to be affected by these changes…..

  1. Higher rate or additional rate tax payers
  2. Landlords with other sources of income (such as income from employment)
  3. Those with high levels of debt against their buy to let property
  4. Those paying high rates of interest
  5. Those earning close to a benefit ceiling (such as child benefit)

 

These changes are one of many introduced in recent years that could massively increase a property investors annual tax liability, for more information about these changes and how they impact on you, contact us today.