During the Chancellor's Summer Budget 2015 he made the announcement for plans to restrict the tax relief given to landlords for their finance costs. The decision was stated to have been made in order to remove the tax benefit available to a landlord but not to an owner occupier. Whether this is indeed the reason, or whether the thought of a projected increase in annual tax take of over £665m by year 5 provided a bigger incentive…, the new rules are to be phased in from 6 April 2017. Furnished holiday lettings are not affected by the rule changes.
So what does this mean?
Currently, finance costs can be deducted from gross rental income as an expense in calculating the taxable profit, or loss, arising in a tax year. Finance costs include mortgage interest (capital repayments have never been relievable for tax purposes), interest on loans to purchase furnishings and fees incurred for taking out or repaying loans/mortgages. Relief in this way is given at the taxpayer's marginal rate of tax - for example, a higher rate taxpayer will receive relief at 40%.
The new rules, once fully implemented from 2020/21, will provide a restriction to relief for finance costs limited to the basic rate tax band. This will be 20% while the "tax lock"applies.
There is a phased introduction of the new rules from April 2017 which provides relief as follows:
• 2017/18 - deduction of 75% of finance costs from profit and basic rate tax reduction for 25% of finance costs.
• 2018/19 - deduction of 50% of finance costs and 50% given as a basic rate deduction.
• 2019/20 - deduction of 25% of finance costs and 75% given as a basic rate deduction.
• 2020/21 onwards - basic rate deduction for all finance costs.
How will this affect me?
A higher rate taxpayer with a buy to let property generating £20,000 income each year, which was acquired with an interest only mortgage with annual repayments of £15,000, would currently pay tax of £2,000 a year (assuming the interest is fully allowable and there are no other expenses).
As can be seen in the above table, the tax payable increases by 150% over a five year period.
Is a tax increase the only impact?
In a word, no. Whilst a direct increase in tax is a concern, there are other areas which may be affected by the rule changes.
The increase in taxable income may alter the availability of personal allowances, age related allowances, income assessed educational grants, the high income child benefit charge or other state benefits. This list is not exhaustive and there may well be other areas impacted negatively. Each taxpayer should consider their own circumstances and assess how the changes will affect them.
What can I do to reduce the impact of the changes?
The use of a company will mean that finance charges are deducted in full and the new rules do not apply. The tax rate on profits is determined by the corporation tax rate, currently 20%, and not the individual's marginal rate.
However, there will be an increase in administration costs for the preparation of accounts, corporation tax returns, etc and these would need to be reviewed ahead of making any financial decisions.
In addition to the running costs of using a company, taxpayers would need to consider the costs association with putting the property into the company in the first place. The transfer to the company would be a disposal for capital gains tax purposes and Stamp Duty Land Tax ("SDLT") is likely to apply when the company acquires the property. Transfers of 6 or more properties are viewed as being a transfer of a business for SDLT purposes and charged at a flat rate of 4% rather than being subject to the usual property rates.
If you are concerned about the impact the rule changes will have on your tax position or would like to consider transferring property to a family member with a lower tax rate or to a company, please talk to your usual Gepp and Sons contact or Marc Dorsett on 01245 493939 or firstname.lastname@example.org .