Loan interest and finance cost restrictions
The Chancellor announced in the 2015 summer budget, that after 6 April 2017, there would be changes to tax relief on interest paid on loans and mortgages, used to buy or improve properties let for residential purposes. The new rules will limit tax relief to the basic rate of tax. The rules will operate by disallowing the interest included in the rental expenses and therefore increasing the taxable rental profits. A tax credit for 20% of the interest disallowed will then be deducted from your tax liability.
The changes will be phased in from 6 April 2017 which will in the first year disallow 25% of the interest and instead allow a tax credit at the basic rate of tax. The percentage affected will be 50% of the interest in 2018/19, 75% in 2019/20 and 100% in 2020/21. During this period, the allowable part of the interest costs will remain unaffected and be treated as a deduction from your rental profits. If the tax credit cannot be relieved in full, it cannot create a repayment, instead the unrelieved tax credit will be carried forward to offset against future rental profits.
The new rules will have a substantial effect on the tax liabilities that many landlords will have to pay by the time the measures take their full effect in 2020/21.
The example below shows the effect on a higher rate taxpayer with annual rental income of £20,000 and loan interest of £12,000.
1. Assumes the rental profit falls within the taxpayer’s 40% band
2. Interest only mortgage
3. All figures remain constant for comparison purposes
There are other consequences of the changes. For example, if your income will now exceed £50,000 after allowing for the removal of the interest relief you may have to repay some or all of any child benefit received. Your entitlement to Tax Credits may also be affected if you are currently eligible to claim them.
There are a number of planning possibilities for those affected, but the first stage is to calculate the effects of the changes. This would normally involve recalculating your tax liability based on the current figures, but taking into account the tax changes to see how much the tax increases. After this a further calculation could be made which takes into account some increase in the interest rate. That will allow you to consider whether you need to do anything to plan for the changes.
If planning is needed then the following could be considered:Property transfer
One option could be to transfer some or all of the property to your spouse, who may have unused basic rate band which would limit the effect of the interest restriction. A form will need to go to the Revenue if this is done.Incorporation
As the new rules do not apply to companies, you may consider incorporation. This may be attractive to some as the rate of tax for companies is only 20%. It is important to think about the tax involved in the future both for the company and then on extracting the profits following recent changes to the taxation of dividends. The tax on selling properties in the future should also be considered.
The capital gains tax and SDLT implications of transferring existing properties to the company will need to be considered as there can be tax charged—it is possible in certain circumstances to transfer properties to the company without either of these arising, but advice should be taken on this before proceeding to avoid unexpected large liabilities.Reducing the level of borrowings
You could also consider selling some properties in the portfolio to reduce the amount of interest payable. The capital gains tax implications of this should be considered, and the amount of tax that will arise estimated in advance.
The conditions of any mortgages and the possible cost of replacement mortgages would need to be considered with these alternative routes. Changes to the replacement of furniture
From April 2016, the Wear and Tear Allowance will be replaced, and landlords will be able to deduct the actual costs of the replacement of furnishing. At present landlords of furnished residential property can elect to claim wear and tear allowance at a rate of 10% of their rental income each year, instead of claiming the actual cost of replacing the furnishing. The new relief will only apply to the replacement of a furnishing and not the initial cost. The new replacement furniture relief will include furniture, furnishings, appliances and kitchenware used by the tenant such as:
- moveable furniture or furnishings, such as beds or suites
- fridges and freezers
- carpets and floor coverings
- crockery or cutlery.
The replacement of fixtures integral to the building would be treated as repairs to the building, and would therefore be tax deductible. Some examples of such expenditure would be:
- baths and basins
- fitted kitchen units.
The new rules will apply to residential property landlords of both unfurnished and furnished properties. This is an improvement on the current situation where landlords of unfurnished properties cannot claim the replacement costs of carpets or free standing white goods.
If you would like to discuss in more detail any tax matter in relation to residential properties please contact us.