Changes to tax relief for residential landlords

Q. I understand that the second phase of interest relief restrictions has now been introduced. Is there anything I should do to prepare for this?

A. The gradual phasing out of tax relief for interest at higher rates of income tax entered its second phase on April 6th 2018.

Previously landlords who were higher rate tax payers could receive relief at their highest rate of tax – 40% or 45%. They could offset the interest they paid on their mortgage/loan repayments against the income they received from rent payments before paying tax.

Now, restrictions are being phased in so the amount of Income Tax relief all landlords can receive on residential property finance costs from April 6th 2020 will be restricted to the basic rate of tax – currently 20%.

What are the tax changes and who is affected?

This affects investors who let residential properties as an individual, or in a partnership or trust, changing how they receive relief for interest and other finance costs.

No longer will finance costs be taken into account when calculating taxable property profits. Instead, once Income Tax on property profits and any other sources of income have been worked out, Income Tax liability will be reduced by a basic rate ‘tax reduction’.

This change is being phased in slowly, starting from the tax year ending April 5th 2018 and becoming fully in place by April 6th 2020.

For the year ending April 5th 2018, 25% of interest was restricted to the basic rate.

Now Phase 2 is in place, so for the year to April 5th 2019, 50% of interest is restricted to the basic rate – this will have to be paid by January 31st 2019.

For the year to April 5th 2020, 75% of interest will be restricted to the basic rate and after that, 100% of interest will be restricted to the basic rate.

What should landlords do?

Landlords should be aware that these changes are happening now and budget accordingly if they are going to be affected. Only those paying higher rates of tax will be affected.

Setting up a business to own rental properties could be a solution as these companies would not be affected by the changes. However, this requires specialist advice as incorporation would incur other costs – possibly higher business mortgage rates and Stamp Duty when transferring assets to the new business.

Instead, in order to reduce costs, another option would be for landlords to look at their existing mortgage and see if they can obtain a better interest rate by remortgaging with another provider.

It is probably difficult for investors to envisage exactly how the changes will affect them so I’ve put together a couple of examples, illustrating how their tax situation might alter once the changes are implemented.

Example 1 – Income Tax payable for year to April 5th 2018

First, let’s look at an example of a UK resident individual earning a gross salary of £50,000. They also own a property which is rented for £28,000 per year. There are expenses of £8,000 and interest on a mortgage of £10,000. The income tax payable for the year ended 5 April 2018 is:

Salary £50,000

Rental income £28,000

Less:
Allowable expenses £8,000

75% of interest £7,500

Total £62,500

Personal allowance £11,500

Taxable income £51,000

Tax:
£33,500 * 20%  £6,700
£17,500 * 40%  £7,000

Less:

Basic rate credit on 25% of interest
£2,500 * 20%  £500

Total income tax  £13,200

Example 2 – Income Tax payable for year to April 5th 2019

In this example, I will look at how the same UK resident individual, again earning a gross salary of £50,000, will fare once the tax changes are implemented for the year to April 5th 2019. Again, they also own a property which is rented for £28,000 per year. There are the same expenses of £8,000 and interest on a mortgage of £10,000. The income tax payable for the year ended 5 April 2019 is:

Salary £50,000

Rental income £28,000

Less:
Allowable expenses £8,000

50% of interest £5,000

Total  £65,000

Personal allowance  £11,850

Taxable income  £53,150

Tax:
£34,500 * 20%  £6,900
£18,650 * 40%  £7,460

Less:

Basic rate credit on 50% of interest
£5,000 * 20%  £1,000

Total income tax  £13,360

As you can see, the effect of this tax restriction is marginal for anyone whose UK income is taxed at the basic rate. Even for higher rate taxpayers, it is still possible to claim tax relief at the basic rate (currently 20%).

And the good news is that, as many investors simply use the rent to pay the mortgage, viewing the long-term capital appreciation of the property as their true investment objective, these changes will have only a limited impact for many.

For more information, either go to https://www.gov.uk/government/news/changes-to-tax-relief-for-residential-landlords or call our Finance Department on 020 7319 9730.