The loss of mortgage interest relief
A number of users have contacted us to share their concern over the proposed tax changes in the Budget that will limit and then remove the ability to off-set BTL mortgage interest payments against rental profits.
One of our users, who understandably wishes to remain anonymous, has outlined how losing the ability to off-set mortgage interest rate is critical to his business model. In his words – ‘I’ve worked so hard to build up my portfolio for my pension and my children just in essence to have it taken away. I’m sure you can see my stance on the subject.’
We thank him for his considerable research, and want to put his specific situation out there, to see whether other landlords have any thoughts or suggestions on how they will need to change their business in light of these changes.
Here is his letter and the responses he received
“Hi Property Hawk
I’ve been a subscriber of your newsletter for years and read it every week! I’ve been having a few issues with the new proposed changes to legislation of tax on buy to let properties and so far not really found a clear answer. I’ve spoke with NLA and not much help there, so I am kind of stuck. The situation looming I don’t think many people realise is huge and I’m extremely concerned. I’ve spoke with my accountant and a few others and there is no real set solution so far it seems.
Have a look at my example/position as I know more people will be facing the same problem:
Example of my loss of mortgage interest relief
For simplicity sake I’ve just assumed no tax allowance so 20% on up to 50k and 40k on anything over.
Problem I’m facing is my rent is approx 200k a year, with 150k say interest payment — so a simplified version with no tax break etc
Currently 50k Profit @ 20% tax = £10k tax
New system would be:
200k In rent, 10k on first 50k (50k @ 20%) and 40% on the other 150k – 60k totalling 70K tax
minus 150k – 20% tax relief 30k = 40k Tax
So my tax is going up by 4 times and doesn’t make it worth it, its unfair as it is run as a business.
However 50k profit – 40k tax is still 10k Profit
Worse situation is when interest rates go up and say I am paying 170k in interest payments I’m facing 70k tax minus 34k relief (£170k @ 20% ) so tax is 36k however I’m only making 30k thus a 6k loss in total.
He got this response from a senior tax expert:
Firstly, your calculation of the worst case impact is correct. Based on mortgage interest of £150,000, the total tax hit will be £30,000 p.a. i.e. a 20% tax restriction on his mortgage interest deductions. The rules are being phased in over 5 years, so this will not be an immediate impact and it allows some time to adapt to the changes.
The article that he has found is a pretty good summary of the situation and the possible alternatives available to him:
1. Does his wife have any unused tax allowances or basic rate band? If so, transferring a larger interest in the properties to her would help to avoid the tax increase, because basic rate taxpayers are not affected by the restriction on interest deductions;
2. Is he able to manage his salary and dividends from the trading company to keep below the basic rate band? Again, this could include transferring some income to his wife if appropriate;
3. It may be worth looking at selling one or two of the properties and using that to reduce the debt on the others. The ones you would look at selling would be those that are contributing least profit i.e. where rental income minus mortgage interest is lowest. Properties like this would have worked better when there was a full tax deduction for the interest, but following the changes they could actually end up costing money after tax. I appreciate this means reducing the number of properties and hence the potential for future capital growth, but it is probably worth a close review of his portfolio to see if now might be a good time to exit from any of them.
4. It may be appropriate for some investors to incorporate all or part of their property portfolio. This is a pretty big step and in most cases I would not recommend putting residential property in a company for various reasons (stamp duty, higher overall capital gains tax on a sale etc) but in some circumstances it might work.
Unfortunately I don’t think there is a silver bullet to solve this situation, but we are still looking out for any better ideas.
Our user, got this back from his local MP
The Politicians response to loss of mortgage interest relief
Answer on mortgage interest changes from Parliament
A constituent contacted you concerned about changes announced in the Budget that affect landlords: specifically, restricting the relief on finance costs that landlords of residential property can get to the basic rate of tax. You asked for a basic explanation of the changes and whether the constituent’s assessment of how this change could increase someone’s tax was accurate.
The restriction announced in the March Budget on the amount that landlords of residential property can claim in tax relief will almost certainly increase your constituent’s tax bill assuming that he is operating as an individual and not as a company. However the measure is due to be phased in over a number of years and it is possible that your constituent might benefit from reducing the amount of his outstanding mortgage/s and/or changing the ownership of the properties to a company structure.
What is this measure?
The Budget report sets out the context for this measure as follows: (Budget 2015, HC 264, March 2015 para 1.190-1)
Landlords can deduct costs they incur when calculating the tax they pay on their rental income. A large portion of those costs are interest payments on the mortgage. Mortgage Interest Relief was withdrawn from homeowners 15 years ago. However, landlords still receive the relief. The ability to deduct these costs puts investing in a rental property at an advantage. Tax relief for finance costs is particularly beneficial for wealthier landlords with larger incomes, as every £1 of finance cost they incur allows them to pay 40p or 45p less tax … The government will restrict the relief on finance costs that landlords of residential property can get to the basic rate of income tax. The restriction will be phased in over 4 years, starting from April 2017. This will reduce the distorting effect the tax treatment of property has on investment and mean individual landlords are not treated differently based on the rate of income tax that they pay. It will also shift the balance between landlords and homeowners.
Details on how this will work are given in HMRC’s Tax Information & Impact Note: Restricting finance cost relief for individual landlords, 8 July 2015:
Legislation will be published in Summer Finance Bill 2015 to restrict deductions from property income for finance costs for residential properties for individuals and to introduce a tax reduction at the basic rate of Income Tax.
Deductions from property income will be restricted to:
- 75% for 2017 to 2018
- 50% for 2018 to 2019
- 25% for 2019 to 2020
- 0% for 2020 to 2021 and beyond
Individuals will be able to claim a basic rate tax reduction from their Income Tax liability on the portion of finance costs not deducted in calculating the profit. In practice this tax reduction will be calculated as 20% of the lower of the:
- finance costs not deducted from income in the tax year (25% for 2017 to 2018, 50% for 2018 to 2019, 75% for 2019 to 2020 and 100% thereafter)
- profits of the property business in the tax year
- total income (excluding savings income and dividend income) that exceeds the personal allowance and blind person’s allowance in the tax year
Any excess finance costs may be carried forward to following years if the tax reduction has been limited to 20% of the profits of the property business in the tax year.
Provision for this measure is made by clause 24 of the Finance Bill 2015; details are given in the explanatory notes to the Bill.
Is the constituent’s calculation correct?
The constituent estimates how much tax would be charged on taxable income totalling £200,000. However, at the moment, we do not know what the thresholds will be for the three rates of income tax, assuming no change is made to the rates of tax themselves by 2021 when the measure will be fully implemented.
Is there a proposal to restrict relief on equivalent interest payments made by companies?
No. As made clear in HMRC’s ‘tax information note’ cited above, the change is to affect deductions from property income for finance costs for residential properties for individuals – and “there is no additional impact on business.” It is likely that some individuals may respond to these changes by incorporating their businesses.
The possible effect of rising interest rates.
Your constituent mentions the possibility that any future rise in mortgage interest rates will further reduce his profits and perhaps even force him into a loss. Given that the bank rate has been at a record low level of 0.5% since March 2009 it is likely that the rate will rise. There is still considerable uncertainty over when the first rise will be and how great the increase is likely to be. However given the extremely low level of the current rate any rise, even a relatively modest 0.25%, would have a quite considerable percentage rise for mortgage payers.
I would just mention in passing that as well as the profits your constituent experiences on the rental income it is highly likely that the value of the properties will have increased over the years. It is unclear from his email precisely how long your constituent has owned his portfolio of properties but he does give the impression that it has been over a considerable number of years. There are no current plans to alter the rate of any Capital Gains Tax payable on the properties.
I hope that this is of assistance.
Senior Parliamentary Assistant
Angela Rayner MP
House of Commons
So what are Property Hawk’s thoughts –
Examples of loss of mortgage interest relief for landlords
The Investors Chronicle published useful article setting out several examples of how the restriction on mortgage interest relief will effect landlords. As outlined above the restrictions start in 2017-18 tax year and will become fully effective by 2020-21. To see the worked examples have a look here.
How will landlords respond to the tax changes?
A recent survey by Rentify of landlords attitudes following the budget tax changes expect rents to rise with 21% of landlords expressing the view that they are extremely likely to increase rents. Whilst 35% are ‘somewhat likely’ to up their rents.
I personally think that the picture will be far more mixed. I can see London landlords, who are highly leveraged being forced to increase their rents to recap some of their tax losses in future years. Previously, they might have been some what more laissez faire, content to generate what was seen as a reasonable rates of return. In other areas of the country where rental demand is less high, landlords may struggle to pass on any substantive element of the extra tax charge to their tenants.
Dealing with removal of higher rate mortgage interest rate relief.
1. Consider converting your buy-to-let to a furnished holiday let
Sometimes being a landlord life throws you a curved ball. It’s how you deal with these things and sometimes this may involve a little lateral thinking. I’m currently buying a property, which is equally suitable as a buy-to-let property and also a holiday let. Luckily it’s located in a tourist hotspot near the centre of Bakewell in the Peak District. Having viewed the recent tax changes my approach to letting this property has been clarified. I will not be letting it as a buy-to-let because my intention is to take a significant mortgage in the realm of 75% Loan to value. On the purchase price of £300,000 this would give me a buy-to-let loan of £225,000 and a whopping tax liability under the new proposed tax system of £3-4,000 a year which will clearly push me into a income loss for this as a stand alone investment.
On the other hand I have no experience of holiday lets so this will be a new business venture for me. Sometimes though with business you have to take up new challenges as they present themselves. The big advantage of Furnished Holiday Lets is that they are treated as a trade although HMRC are keen to point out that they are not a trade. As a trade a landlord has the ability to offset all their interest payments as a business expense. There are also other expenses over and above those allowable to a trade than are available to a buy-to-let landlord.
Clearly, not all areas or buy-to-lets will be suitable as holiday lets. However, in London and certain towns or areas turning your buy-to-let into a holiday let may be away of retaining the full tax advantages of offsetting your interest payments. Short term lets may present an alternative to those landlords who are looking to find a profitable way of renting out their space. Just witness the rise of Airbnb.
2. Move into one of your buy-to-let’s
It might be a drastic step but if you don’t have a residential mortgage then you may want to look at moving home. For many landlords this may not be practical. This is because you’re buy-to-let’s are not suitable family accommodation or where you want to live. However, it could be a way of wiping out the extra tax liability that a large mortgage on a buy-to-let loan now may represent.
3. Holding your portfolio in a company
There are many disadvantages of holding buy-to-let property in a limited company, not least the considerable administrative cost and responsibilities of running a company. The main advantage of holding buy-to-let property in a company is that rental profits are taxed at the corporation rate; which is currently 20% and due to drop to 18% by 2020. Holding properties in a company is particularly tax efficient where profits are retained to purchase more properties in the company. The advantage of holding a buy-to-let in a company is that a landlord is able to off set their full amount of mortgage interest against their profits. When a landlord looks to distribute the profits; which would be taxed at the presiding level of corporation tax they would have to pay income tax at their marginal rate. For many this would be much less than the proposed system of tax on turnover.
4. Use your partners tax advantages if they are paying tax at a lower marginal rate
If you transfer some of your property or an element of it to a partner to take advantage of their tax allowances then this could cut your overall tax liability. Remember one of the options is to split the rent
which could substantially reduce your personal rental profit for your rental business.
5. Lobby your MP and politicians
This change is not a done deal. If you believe in democracy there is still time to change the policy so make a song and dance about it and lobby your MP and politicians and sign the online petition for the Governement to reconsider changes to mortgage interest relief.
Why has the Chancellor acted on higher rate mortgage interest tax?
I can see reasons why the Chancellor has decided to act now and that the action could be unilaterally targeted at just higher rate tax payers.
Here are some of them:
1. The Chancellor has seen that there is a possibility for higher rate tax payers leveraging up to buy large or expensive property (particularly in London) and use this borrowing power and low rates of interest to then make significant rental profits with large interest rate tax breaks. This is both politically unpopular with ‘generation rent’ who feel that they are being priced out of the housing market. It is also perceived as an unfair tax advantage for landlords who were seen as being able to offset their interest payments against their tax bill in a way that homeowners couldn’t since the abolition of MIRAS.
2. The removal of the higher rate mortgage interest relief could potentially save the government money through tax relief. Figures aren’t available and his actions may have a counter productive impact as many landlords may be put off purchasing a buy-to-let property or adding to their portfolio. In addition some landlords will sell. This will then reduce the potential tax take.
3. The fazing out of this tax break is seen as a way of taking the heat out of house price growth, particularly in the capital, which has been significant over the last decade where landlords have been significant purchasers of property.
4. It addresses one of the worries that a buy-to-let bubble may have been forming where people were lured in to taking large debts to build up buy-to-let portfolios and using the low debt level to arbitrage rental profits. Many of these investors could be exposed to a sudden rise in interest rates when the current low rate environment changes representing a sizeable systemic risk to the economy and banking system.
Is the removal of higher rate interest rate justified?
In my eyes, renters and homeowners fail to appreciate that buy-to-let is a not an investment but a micro business. A landlord, however big or small, gives up a lot to get a buy-to-let property up and running – the potential of investing their money in an alternative investments, the fun of spending hard earned money as well as a putting themselves at considerable exposure to financial risk. Will they get tenants? How will these tenants (customers) perform? There are financing risks in terms of the costs of any loan, as well as the risk of capital loss. There is also considerable work involved in maintaining and letting out property. Managing a BTL property is not a passive investment.
The worry is, this latest move by Osbourne is only the precursor to a blanket removal of the facility for landlords to offset mortgage interest costs. The next step could be to extend this change to basic rate tax payers, to bring the tax treatment for landlords to that of homeowners instead of business owners.
This would place a landlord’s tax treatment into a weird in-between place, although running a business they will no longer be treated as such by the tax system. A confusing tax policy that would not be justifiable. Tax policy however is full of these anomalies, and unfortunately landlords cannot bank on things changing any time soon.
Your thoughts please.