Not content with increasing the rate of SDLT by 3% on buy-to-let properties, the chancellor has announced radical changes to interest deductibility, which will make owning buy to let properties less attractive than ever before.
The current position
Buy to let landlords can claim tax relief for the whole amount of their mortgage interest at their personal rate of tax. For example, let's say Mr J (who is a higher rate tax payer) owns one buy to let property. He receives £20,000 rental income per annum. His buy to let property is mortgaged and his mortgage interest amounts to £13,000 annually. In other words, he makes a taxable profit of £7,000, on which he pays tax (at 40%) of £2,800.
In other words, the whole amount of his mortgage interest is set off against his rental income before he has to pay any tax.
Out of the £7,000 of profit HMRC gets £2,800 and Mr J gets £4,200.
What is changing?
By April 2020, tax at 40% will be due on the whole amount of Mr J's rental income, less a tax credit equal to the basic rate of tax. Mr J's tax (at 40%) is calculated by reference to the whole amount of the rental income of £20,000 (i.e. £8,000). From this he will be able to deduct 20% of his £13,000 mortgage interest (i.e. £2,600) thereby reducing his tax from £8,000 to £5,400.
Out of the £7,000 of profit HMRC gets £5,400 and Mr J gets £1,600.
If the interest rate rises by a fraction and Mr J's mortgage interest increases to £15,000, Mr J's profit reduces from £7,000 to £5,000, but his tax reduces by just £400.
Out of the £5,000 of profit HMRC gets £5,000 and Mr J gets £0.
When is it changing?
The changes are being phased in between April 2017 and April 2020 - the percentage of interest eligible for deduction will decrease on a sliding scale throughout that period.
What can be done?
The options are limited:
- Remortgage: switching to a mortgage with a low rate of interest is now more important than ever
- Tax planning: if the landlord is a higher or additional rate tax payer and has a spouse or civil partner who doesn't work, transferring some of the rental income to the spouse to utilise his or her tax free personal allowance is beneficial, although this is only likely to assist in very small scale investments and may already have been done
- Portfolio restructuring: the changes do not have any impact on landlords who do not pay any mortgage interest. These changes are so drastic that we can expect to see some landlord's selling part of their portfolio in order to release capital to pay off the mortgages attached to the retained portfolio
- Incorporate a company: corporation tax will reduce to 18% in 2020 and companies receive a full deduction for mortgage interest. However, income tax at dividend rates has to be paid on any profit extraction by the landlord and transferring existing properties into a company may trigger capital gains tax payable by reference to the current market value together with SDLT (probably with the new surcharge attached), so the tax expense attached to the incorporation is likely to be enough to render this unviable.
These reforms were announced in such a way that very few buy to let investors are likely to be aware of the impact it will have on them. If you wish to discuss this in more detail please feel free to contact a member of our tax team.
This document is for informational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given.