The start of the 2019/20 tax year marks the beginning of the third year of the Government’s restrictions on the income tax relief for interest paid on borrowings of residential landlords who are higher rate taxpayers.
This article sets out the current position for income tax relief on buy-to-let properties and potential planning options for landlords to minimise the tax impact.
What was the position before 6 April 2017?
Landlords were previously 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 higher rate (40%) taxpayer with annual mortgage interest of, say, £10,000 on their buy-to-let property could therefore receive income tax relief of up to £4,000 (£10,000 at 40%) each year.
What new rules were introduced from 6 April 2017?
Income tax relief on all allowable finance costs will be restricted to the basic rate of income tax (currently 20%) for landlords of residential property by 6 April 2021. This restriction is being phased in over 4 years from 6 April 2017. The restrictions apply to individuals, partnerships and trusts, and apply equally to residential property situated in the UK and worldwide. There are a number of exclusions from the restrictions, including: where finance costs are incurred for property development purposes and where loans for your business are secured against residential property. The restriction does not apply to commercial property or where the residential properties qualify to be treated as furnished holiday lets for income tax purposes.
How do the restrictions work in practice?
The landlord has to add back any allowable finance costs to their taxable rental profits with a basic rate tax credit (20%) then being applied to the resulting income tax liability. A landlord with, for example, annual interest costs of £10,000 receives a basic rate tax credit of £2,000 instead of being able to deduct the interest costs from his rental income.
The new rules started to be phased in from the start of the 2017/18 tax year onwards with the level of finance costs subject to the restriction being increased by 25% each year until the 2020/21 tax year when all of the finance costs will be subject to the basic rate cap. In the current 2019/20 tax year the restriction now applies to 75% of allowable finance costs.
What will be the impact for you?
The impact of the changes will depend 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 2019/20 income tax rates).
There will be no impact for basic rate taxpayers unless the restriction results in them being pushed up into the higher rate (41%) tax band. If, for example, the adding back of interest costs resulted in, say, £10,000 of rental profits being subject to income tax at the higher rate then there would be an increase in the taxpayer’s annual income tax liability of £2,100 (£10,000 at 21%).
Higher and additional higher rate taxpayers could be faced with a significant increase in their income tax bills by the 2020/21 tax year. This will especially be the case where the landlord has a high level of loan finance. A higher rate landlord with, for example, annual interest costs in the region of £20,000 would previously have received tax relief of up to £8,000 (£20,000 at 40%). Their annual income tax bill could increase by up to £4,200 (£20,000 at 21%) from the 2020/21 tax year onwards under the new rules. There would also be an increase in the rate of income tax if the new rules result in the taxpayer becoming an additional higher rate taxpayer, where the extra tax will be 26% (the difference between relief previously being available at up to 46% and the restricted relief of 20%).
What can landlords do?
Landlords should, if they have not already done so, carry out a review of the financing of their property portfolios in order to establish the impact of the interest relief restrictions. It will be the case for a number of landlords that the restrictions will have little or no impact in practice. If, however, the capping of the tax relief will result in a material increase in the landlord’s annual income tax liability then the next step will be to 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 charge for secondary homes for transfers on or after 1 April 2016.
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 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.