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Mortgage Interest Relief

First tax year just passed since the mortgage interest relief had been reduced, and even though most of property investors and landlords are aware of it, we are now starting to see the real impact on our tax returns.

With upcoming years bringing further reductions, it is important to understand how the change may affect your property portfolio income and profitability of your investments. This post is a brief recap for those of you who find the mortgage interest relief phase-out still a bit confusing.

How are the mortgage interest relief rules changing?

Whether you own a second home or are professional property investor until April 2017 you could deduct all mortgage interest together with different costs from rental income before calculating your taxable profit. This changes however and by 2020, you will no longer be able to deduct any mortgage interest costs from your taxable profits if the property is owned by an individual, in partnership or in limited liability partnership (LLP).

Although the change is gradual and spans over several year, you will see below that it has an enormous impact on take home income, and in some cases may significantly increase personal tax. This means you should think about and start planning tax strategy for your properties as soon as possible to minimise financial impact and avoid unpleasant tax bill.

The upcoming tax years will bring further reductions in mortgage interest relief as follows:

  • Tax year 2017/18 - 75% of mortgage interest was fully allowed and the remaining 25% available at the basic rate

  • Tax year 2018/19 - 50% of mortgage interest is fully allowed and the remaining 50% available at the basic rate

  • Tax year 2019/20 - 25% of mortgage interest will be fully allowed and the remaining 75% available at the basic rate

  • Tax year 2020/21 - mortgage interest deduction will be only given at the basic rate

What is the impact of changes to the mortgage interest relief rules?

The restriction of mortgage interest relief will effectively push the rental profits up, as year by year through the process more of your rental income will be treated as a profit and less as mortgage cost . This means that even though you may be a basic rate tax payer right now, you could quickly find yourself paying higher rate tax. In some cases it can also reduce your personal allowance (e.g if total income starts exceeding £100,000) and affect your entitlement to child benefit.

Although this change mainly involve mortgage interest, it also affect the finance cost, which includes overdraft, credit cards and fees charged by mortgage brokers or even any loans taken to buy fittings and fixtures.

Lets go through some examples that illustrate the impact of the reduction in the available relief. For overall impact we will use tax rates and personal allowance from 2016/17 tax year, before the changes were made and contrast it with 2020-21.

Tax rates and personal allowance used in examples are as follow: Personal Allowance - up to £11,000 Basic rate - £11,001 to £43,000 Higher rate - £43,001 to £150,000

How will it affect basic rate tax payers?

Mary has a salary of £11,000 and rental income of £20,000 with mortgage interests of £12,000 and other expenses £2,000. Her salary will use up the personal allowance and rental income will fall in the basic rate of tax.

Before April 2017

After April 2020

Both calculations results in the same tax payable.

How will it affect higher rate tax payers?

John has a salary of £43,000 and rental income of £40,000 with mortgage interest of £20,000 and other expenses £5,000. His salary will use up the personal allowance and basic rate of tax. The rental income will fall into higher rate of tax.

Before April 2017

After April 2020

Here the tax credit still stays at 20%, so £20,000 of mortgage interest will only give us credit of £4,000. Therefore in this case the tax payable will increase from 6,000 to £10,000.

What is a tax credit?

The tax credit is a tax reduction available at basic rate and currently set at 20%. It is calculated as the lower of the following amounts:

  • Finance costs - the cost not deducted from rental income during transition years and later the all finance costs plus any brought forward from previous years

  • Property business profits - the profits available from your rental income during tax year

  • Adjusted total income - the income ( after losses and reliefs and excluding savings and dividends income) that exceeds your personal allowance

Note that this tax credit could never create a refund. Additionally if the tax credit is calculated using property business profits or adjusted total income then the difference between the amount and finance costs (mortgage interest) is carried forward to the next year.

What is the impact for tax year 2017/18?

The 2017/18 tax year was the first year of reductions bringing mortgage interest relief down to 75%. Below is an example of how this affects potential basic rate tax payer.

Mark has a salary of £11,000 and the rental income of £15,000 with mortgage interest of £8,000 and other expenses £1,000.

The tax credit is calculated as 25% of mortgage interest (25% of £8,000), which is £2,000 and then 20% available reduction £2,000 x 20% is £400.

What to do next?

The next step is to assess the impact that reduction will have on your property income and select optimal strategy going forward. We are able to determine the impact by looking at the last year of property accounts. Below you will find some tips that may help in tax planning for upcoming years. Remember that not every strategy will match your personal circumstances and it is always best to seek an independent advice.

1. Transfer property over to limited company

In some cases setting up a limited company and transferring properties over may be your preferred choice. Since changes in rules only affect individuals and partnerships and corporation tax is set to reduce to 17% by 2020, you will be able to claim all costs as before April 2017 and make use of corporation tax reduction. One thing to keep in mind here is that the transfer of ownership is treated for tax purposes as a ‘market value’ sale, hence will attract capital gains tax as well as the stamp duty with 3% supplement. In certain cases you may be eligible for incorporation relief, which weaves Capital Gains Tax, but this must be assessed based on personal circumstances. It is also worth mentioning that even though you may not be able to transfer existing properties, any new purchases can benefit from being set up under limited company.

2. Transfer the ownership to spouse

You could consider including your spouse and transfer some of the properties to balance income between you and your partner. Aim is to keep both partners below higher rate tax threshold, therefore making full use of basic rate tax.

3. Reduce your mortgages

It may be beneficial to speak to a mortgage broker and find out if some of your higher interest mortgages can be refinanced at the lower rates. This way you will end up with lower amount to pay and being restricted with new rules. Another option to consider is selling some of your properties, especially those yielding below expectations. Disposing of assets may not be ideal but reinvesting proceeds in properties with higher yields may turn to be more beneficial long term and will reduce your debt exposure.

4. Set up a management company

Managing multiple properties can consume substantial amount of time so you may consider setting up a dedicated management company. The management company charge will be treated as an expense, subtracted from rental income and effectively reduce your profits. The fees may include letting agent services, accounts services or arrangement fee for insurance etc.

5. Make pension or Gift Aid charity contributions

Consider making contributions to your pension or donating through Gift Aid, as it will increase basic rate band threshold. This means that more of your income will be charged at basic rate rather than higher rate.

6. Claim every expense possible

Managing and keeping track of expenses can be a chore but make sure you do it regularly and diligently. Regular reviews and claiming every expense possible will reduce both personal tax to pay and corporation tax for property under limited company. Additionally if your property has a long due repairs, it may be a good time to start the work, as the expenses will bring the rental profits down and in some case could help to bring to the basic rate threshold. If you find managing expenses difficult or time consuming, it may be worth to look around for a good online accounting software or hire a bookkeeper.

7. Convert property to Furnished Holiday Letting

It is worth considering converting some of your properties to Furnished Holiday Lettings (FHLs) as they have special tax rules for rental income. When you let property as FHL, you can claim Capital Gains Tax reliefs for traders, are entitled to plant and machinery capital allowances (e.g. furniture, equipment and fixtures) as well as profits can be treated as earnings for pension purposes. Note however that FHLs are more involving than standard buy to lets and require adhering to certain occupation, availability and letting conditions, e.g. being publicly available to let for at least 210 days and let for at least 105 day per year.

As the best solution will vary depends on your situation, please feel free to contact us if you would like to arrange meeting to prepare personalised strategy.

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