Many landlords have historically been willing to take out large loans to finance the purchase of buy to let properties on the basis that a tax deduction could be claimed against the rental income for the whole of the interest paid.
Income tax relief for interest paid on borrowings is however now restricted to the basic rate of income tax (20%). This article explains the impact of this restriction and potential planning options for landlords.
What was the position before 6 April 2017?
Prior to 6 April 2017 landlords were able to obtain a full income tax deduction for allowable finance costs (e.g. mortgage loan interest, arrangement fees, repayment fees, etc.) relating to buy-to-let residential property. A Scottish higher rate (2016/17 tax year - 40%) taxpayer with annual mortgage interest of, say, £10,000 on their buy-to-let property therefore received income tax relief of up to £4,000 (£10,000 at 40%) each year.
What is the current position?
The restriction to income tax relief has been phased in over 4 years from 2016/17 and with effect from 6 April 2020 all finance costs are subject to the basic rate cap. From this date a deduction cannot be taken for finance costs in calculating the profits chargeable to income tax but relief is available as an income tax reduction at the basic rate.
The restriction applies to individuals, partnerships and trusts and apply equally to residential property situated in the UK and overseas. The new rules do not apply to commercial property, where finance costs are incurred for property development purposes or where the residential properties qualify to be treated as furnished holiday lets for income tax purposes.
What is the impact of the restriction?
The impact of the restriction depends upon a number of factors including the level of the landlord’s rental income, the level of annual interest costs and whether the landlord is a basic rate (20%), intermediate rate (21%), higher rate (41%) or additional higher rate (46%) taxpayer (Scottish resident taxpayer’s 2021/22 income tax rates).
Whether relief is given by way of a deduction from taxable profits or a reduction to their income tax liability should have little impact on landlords who are basic rate taxpayers. However, the restriction can move the landlord into the higher rate (41%) tax band. If for example, the adding back of interest costs resulted in, say, £10,000 of income being taxed at the higher rate the landlord would pay additional tax of £2,100.
Higher and additional rate taxpayers can pay substantially more tax under current rules than they would have done under the system in place prior to 6 April 2017 ('old rules'). If we take as an example a landlord who has other income of £60,000, rental income after other expenses of £30,000 and pays loan interest of £20,000 their tax liability calculated under the old rules and current rules is set out below.
The landlord pays additional tax of £4,200 due to relief for loan interest being restricted to 20%.
What can landlords do?
New or existing landlords, particularly those who are higher or additional rate taxpayers and those who have large loans on their properties should factor in the impact of the interest relief restrictions. It is no longer possible for landlords to calculate their net of tax profits by simply deducting all expenses including loan interest from their rental income.
Existing landlords who have seen their tax liabilities increase year on year with the increased restrictions on finance costs should consider whether any practical planning measures can be implemented to minimise the impact of the proposed changes.
Landlords may consider transferring all or part of their interests in buy-to-let properties to their spouse or civil partner if it results in the rental profits being subject to a lower rate of income tax. There would be no capital gains tax (CGT) charge on a transfer of residential property interests between spouses or civil partners. Transfers to children or other family members could also reduce the overall income tax exposure in the future. It is important, however, to remember that any capital gains arising on the transfer of property interests to other family members will potentially be subject to CGT at up to a rate of 28%. The use of a family trust (subject to certain valuation limits) to hold property interests could provide a workable solution where there would be substantial capital gains arising on the transfer of properties. The LBTT/SDLT implications of transfers to spouses, civil partners or other family members will depend on both the level of the outstanding mortgage being assigned with the property and also the impact of the supplementary LBTT/SDLT additional dwelling supplement charge for transfers of ‘second’ homes.
Landlords could also consider transferring their interests in buy-to-let property into a company. Rental profits in a company would be subject to corporation tax (currently 19%), which compares very favourably to income tax of up to 41/46% in a Scottish resident taxpayer’s hands. There could therefore be substantial tax savings even though the actual rate of tax relief is ultimately going to be the same as under the restriction (20%). The potential tax benefits do, however, have to be weighed up against both the tax costs of transferring property interests into a company and extracting the post-tax profits from the company. The transfer of property interests into the company will be treated as taking place at market value for both CGT and LBTT/SDLT purposes. Post-tax profits arising from rental income or on the sale of property interests held in the company will generally be subject to income tax or CGT when extracted from the company. Whether or not this is an issue in practice will depend upon a number of factors, including the landlord’s personal circumstances, sources and levels of other taxable income, and whether they rely upon a regular income stream from the rental income.
Landlords should also consider the non-tax implications of any transfer of their property interests. This will include reviewing the potential implications of, for example, matrimonial breakdown, bankruptcy and death (e.g. potential legal rights claims) together with the costs relating to transferring property, assigning mortgages, etc. The landlord will also have to check with the mortgage provider that all or part of any outstanding mortgage could be assigned to another party.
There may of course also be ways to minimise the potential impact of the new rules without a change of ownership. It may be viable, for example, to take steps for the residential property to qualify as a furnished holiday let for tax purposes in order to avoid falling foul of the restrictions.
Anderson Strathern have a large number of tax and property specialists who are able to provide you with practical, commercial and tax-effective solutions to guide you through the property tax maze.
For further tax advice, please contact Martin Campbell or Alison Pryde or speak to your usual Anderson Strathern contact. We would strongly recommend that you seek specialist advice tailored to your own circumstances before taking any action.