Changes to Tax Relief on Interest in Respect of Let Domestic Property

The Finance Act 2015 introduced changes to the tax relief available for interest incurred in relation to let domestic property.

What has changed?

From APRIL 2017 tax relief on interest will be restricted in a phased pattern so that by 2020 interest will not be deductible when computing the profits of the business but will instead be allowable as a deduction in computing the profits at 20%. In other words, relief for interest will be capped at 20%. This is a move that will affect many including those with single buy to let properties and those with a larger portfolio. The restriction does not affect furnished holiday lettings.

What do the changes look like in practice?

The best way to review the changes is to look at some examples. Obviously, if you are a basic rate taxpayer, then the change will not affect you – the relief at basic rate is the same as if you were able to claim the expense as a full deduction from the profits of the rental property. But people’s income and tax positions are constantly changing so it is worth reviewing.

The change in relief is being phased in over a 4 year period as follows:

	% of interest charge allowed as a full deduction	% of interest charge restricted to 20% relief	Effective % Rate of Relief
2017/18 tax year (commencing 6th April 2017)	75	25	80
2018/19 tax year (commencing 6th April 2018)	50	50	60
2019/20 tax year (commencing 6th April 2019)	25	75	40
2020/21 tax year (commencing 6th April 2020)	0	100	20

So for example, should your loan interest be a straight £2,000 a year, the relief you would be able to claim would be as follows:

Tax year 2017/18 (ending 5th April 2018)	Tax year 2018/19 (ending 5th April 2019)	Tax year 2019/20 (ending 5th April 2020)	Tax year 2020/21 (ending 5th April 2021)
75% in full:          £1,500 in full against profits	50% in full:          £1,000 in full against profits	25% in full:          £500 in full against profits	0% in full:             NIL straight offset against profits
25% at 20%:        £500 at 20%: £100	50% at 20%:        £1,000 at 20%: £200	75% at 20%:        £1,500 at 20%: £300	100% at 20%:      £2,000 at 20%: £400
Relief for Higher Rate Tax payers:	Relief for Higher Rate Tax payers:	Relief for Higher Rate Tax payers:	Relief for Higher Rate Tax payers
£1,500 at 40% = £600 £500 at 20% = £100 Total £700	£1,000 at 40% = £400 £1,000 at 20% = £200 Total £600	£500 at 40% = £200 £1,500 at 20% = £300 Total £500	None in full £2,000 at 20% = £400 Total £400

(Note: For simplicity, assumes 40% higher rate of tax in all years)

We can also see this in longer examples:

Investor with “Small” Rental Property Income

Edwin is a higher rate taxpayer with two properties bought as investment vehicles. The change in the rules are as follows:

2015/16 Tax Year: PRE CHANGE IN RULES

Rental Income (gross)                                    12,000

Repairs and all other costs                               2,000

Mortgage Interest                                             6,000

Net rental profits                                             £4,000

Tax at 40%                                                      £1,600

Compare this with the situation when the rules have fully changed (please refer to the tapering of reliefs as on page 1).

                2020/21 Tax Year: POST CHANGE IN RULES

Rental Income (gross)                                 12,000

Repairs and all other costs                             2,000

Net rental profits                                        £10,000

Tax at 40%                                                   £4,000

Interest Relief at 20%:

Mortgage Interest £6,000 x 20%                   1,200

Tax due                                                        £2,800

The change is the £6,000 at 20% = £1,200.

Large Investors with Substantial Rental Property Income

Using the example before of Edwin, what if he had established a significant property portfolio on the basis of considerable borrowing, and was thus a higher rate taxpayer with multiple properties bought as investment vehicles? For the ease of the calculation I will assume he has income that uses his basic rate band of tax. The change in the rules would affect him considerably, as follows:

2015/16 Tax Year: PRE CHANGE IN RULES

Rental Income (gross)                                  250,000

Repairs and all other costs                             20,000

Mortgage Interest                                         150,000

Net rental profits                                          £80,000

Tax at 40%                                                   £32,000

Again, let us compare this with the situation when the rules have fully changed (please refer to the tapering of reliefs as on page 1).

                2020/21 Tax Year: POST CHANGE IN RULES

Rental Income (gross)                                  250,000

Repairs and all other costs                             20,000

Net rental profits                                        £230,000

Tax at 40%                                                   £92,000

Interest Relief at 20%:

Mortgage Interest £150,000 x 20%                30,000

Tax due                                                         £62,000

If you consider this in cash terms, after paying the mortgage, Edwin would go from having £80,000 less £32,000 tax due = £48,000 as income, to £18,000 (£80,000 less £62,000 tax in 2020/21). After paying the mortgage, in this example, you could view the tax liability at 77.5% (£62,000 on £80,000 “profit”).

But consider again the position if Edwin has even greater borrowings, or the interest rate increases, and in 2020/21 perhaps the repairs in the property were high. The situation here could be that the tax due is in excess of the “profits” computed before the change in the interest relief:

2020/21 Tax Year: POST CHANGE IN RULES

Rental Income (gross)                                    300,000

Repairs and all other costs                               40,000

Net rental profits                                          £260,000

Tax at 40%                                                   £104,000

Interest Relief at 20%:

Mortgage Interest £200,000 x 20%                  40,000

Tax due   

                                                                       £64,000

In cash terms, Edwin has profits of £260,000 less £200,000 mortgage interest, so has £60,000 cash surplus. However, the tax due now is £64,000, so in cash terms, he is paying out £4,000 for the year from his rental income of £300,000!

Please note that I have not adjusted the higher rate of tax which will be partly at 45% for the additional higher rate – potentially making the example even worse.

What Can You Do?

As Chartered Accountants we are not authorised to give financial advice, but can provide you with potential solutions to the situation. These would be on a case by case basis and therefore the following should be seen only as examples. The potential tax planning might be one of the following:

• Full incorporation – this would involve moving properties and associated loans into a Limited Company.  This will involve professional fees for setting the company up and legal fees for transfer of deeds into the Limited company and ongoing, there would be advice required with regards to extracting the profits from the company to the owners/directors. Stamp Duty land tax would ordinarily be available, but relief might be available if the incorporation is of a partnership (i.e. the incorporation is of a partnership not of property owned by individuals). Specialist advice is sought here.
• Pay down borrowings – this would only be feasible in some circumstances, and again, would be on a case by case basis.
• Sell properties – this would remove the issue but might incur capital gains tax – some of which might be at 28%. Consideration as to the market would be needed and what to do with the proceeds to replace the potential loss of income.
• Incur the extra tax – a simple solution but for many higher rate taxpayers they might obviously be disappointed to pay the additional tax but may be in a position where the deemed (potential) increase in the property value and the lack of desirable alternatives means they will pay the additional tax incurred by the loss of the interest relief.
• Review the ownership of the properties – is there a spouse with an unused basic rate band of income tax who you could transfer the property into joint names? This has implications outside of potential tax savings of course.

Other Considerations

What will your income position be like in 2020/21 when the relief is fully implemented at the basic rate only? Will this affect your decisions now?

Availability of finance – if you wished to move into a Limited company, is the lending available?

Change in interest rates – if the tax burden will increase with the current low interest rates, what would your situation be if the interest rate increased?

How much of your mortgage will be repaid by 2020/21? Will this affect your tax planning.

We can help

This leaflet should be used as a general guide and appropriate advice should be sought in all cases when considering the future of any investments in properties. We offer a free initial consultation and would be more than happy to meet with you to discuss matters in general before then giving appropriate advice. To arrange this please call: 01395 516658 or email advice@easterbrooks.co.uk.

The is a general guide and Easterbrook Eaton Limited, neither owes nor accepts any duty to any party and shall not be liable for any loss, damage or expense of whatsoever nature which is caused by their reliance on the information contained herein.