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17 December 2015

The Summer Budget 2015 announced changes to restrict relief for buy-to-let (BTL) landlords of residential property. There have been calls of ‘bah humbug’ from landlords, as the Chancellor launched a two pronged attack which could result in significant tax increases on rental businesses. These proposals have instigated much negative press, along with an unsuccessful petition to the government by landlords.

Whether these changes will lead to landlords selling up, or increasing rents to cover the additional tax costs, will remain to be seen. Initial indications, however, suggest the market will remain buoyant as low fixed rate mortgages continue to be offered keeping borrowing costs down.

Mortgage interest relief restriction

The first measure was to restrict relief for mortgage interest costs on residential properties to the basic rate of tax.

This restriction is not set to home in until April 2017 and will be phased in over four years. From 2017/18 higher/additional rate relief will only be available on 75% of a landlord’s mortgage interest, with the remaining 25% attracting basic rate tax relief only. This proportion will increase by 25% each year until 2020/21 when 100% of a landlord’s mortgage interest will only get basic rate tax relief.

Who will be affected? 

Any buy-to-let landlords with mortgages on their residential rental properties could be affected by the change. Even though the headlines were around higher rate and additional rate taxpayers being restricted to basic rate tax relief, basic rate taxpayers could be pushed into the 40% tax bracket as a result of these changes. This is because rather than a straight deduction of interest from rental profits, the new rules provide instead for a tax credit.

Below are a couple of examples of the potential additional tax payable for a higher rate and basic rate taxpayer. For the purpose of these examples we have assumed a personal allowance of £11,000 in both years and a basic rate band of £32,000. For simplicity, it has also been assumed that the only expense against the rental business is the mortgage interest.

Example 1

Emma, a higher rate taxpayer, owns a buy-to-let property worth £350,000, with an interest rate of 4% (i.e. interest cost of £14,000 per annum) and gross rental income of £18,000.

 

In 2021 Emma would have additional tax of £2,800 to pay as a result of the new rules. Emma’s effective tax rate on her rental profits will be 110% (i.e. £4,400 tax versus £4,000 profit).

Example 2

Karen owns a buy-to-let property with the same income and expenses as Emma but is a basic rate taxpayer and believes that she will not be caught by the new rules.

 

In 2021 (assuming that the bandings are still the same) Karen would have additional tax of £2,800 to pay. In this example, Karen will have an effective tax rate of 90% against her rental profits (i.e. £3,600 tax against a £4,000 profit).

The above examples show how the effective tax rate can be significant and quite unexpected.

Furnished properties – wear and tear allowance 

The second measure is to abolish the wear and tear allowance from April 2016. Rather than a straight 10% deduction against gross rents for furnished properties, landlords will instead be required to deduct the actual cost of replacing furnishings in the relevant tax year.

This change could lead to fluctuating tax bills for the taxpayer and may result in an overall increase in tax for many landlords as they are unlikely to replace furniture each year. If, however, you are planning to incur significant costs on replacing furniture in the near future, you may wish to defer this until after April 2016 to maximise your relief.

The only landlords who are likely to be unaffected by the new rules are those that own furnished holiday lets. They can continue to claim capital allowances for furnishings and any loans relating to furnished holiday lets will continue to receive full relief for mortgage interest costs.

Where we can help 

We can help you to calculate the additional tax that will be payable and explore options in relation to the best holding for your property investments. There may be opportunities to mitigate the effects of these measures through the use of property companies, trusts or simply bringing spouses into the property business.