From 6 April 2017, there are new rules to restrict tax relief on mortgage interest costs for residential property landlords. Tax relief for interest (and any other finance costs relating to the property) will be restricted to the basic rate of tax.
The rules work so that the rental profits are taxed before any finance costs. A deduction of 20% of the finance costs is then subsequently applied. This calculation method of the tax due means that it is not only higher rate taxpayers that will be affected by the new rules, but basic rate taxpayers could also be tipped into the higher rate tax band. For some worked examples see our article in our Winter 2015 Talking Tax. The calculations are further complicated because the rules are being phased in over four years so that only 25% of finance costs will be restricted to the basic rate in 2017 and then increasing by 25% each year, until fully implemented by 2020.
We have calculated effective tax rates of over 100% on rental profits for some clients, making it unsustainable in certain cases to continue with their current operating structure. There are ways, however, that the impacts of the rules can be mitigated, a few of which have been set out below.
If a spouse pays tax at a lower rate, or does not work at all, it may be more tax efficient to transfer part or all of the property(ies) to them. With the personal allowance at £11,500 from April 2017 and the basic rate band extended to £33,500, taxable income (before finance costs) would need to be kept below £45,000 to avoid being taxed at the higher rate.
Partnerships are subject to the new rules in the same way as individuals. However, spreading the rental income amongst more than one person by establishing a partnership (e.g. with family members) could also be considered.
The new rules only apply to individuals running a residential property business and not companies. One possible option, therefore, could be to look at incorporating the property business.
Tax charges such as capital gains tax and stamp duty land tax could be triggered on the transfer of the property(ies) into a company, however, there are ways in which these can be minimised and in some cases reduced to nil, depending on the specific circumstances of the existing business.
Modelling would also need to be undertaken to determine the tax savings that could be achieved under a company structure, minus the additional costs to run a company.
If you have any questions on how the new rules work, would like to understand what impact it will have on your tax bill and/or what you can do to try and minimise the impact, please do get in touch with Nick Haines or your usual tax contact.