Angela Clegg examines the tough landscape for landlords with tax relief restriction on finance costs taking full effect alongside rising interest rates.
The restriction for tax relief on finance costs incurred by unincorporated landlords (excluding furnished holiday lets) was phased in from 6 April 2017, taking full effect from 6 April 2020. This means that many buy-to-let (BTL) owners have already felt the pinch on their cash returns.
To make matters worse, the interest on fixed-rate mortgage deals available for landlords has now reached a 10-year high, with the average BTL two-year fixed-term deal rising by 1.63% over the past two years from 2.84% in September 2020 to 4.47% at the start of September 2022. This means that the landlord of a £250,000 BTL home will be facing an increased finance cost of more than £3,000 per annum, assuming they have a 25% deposit and an interest-only mortgage.
Tax relief restriction exacerbates rising finance costs
This hike in interest rates is only exacerbated by the restriction on tax relief for interest. The former deduction for finance costs has been replaced and limited to a tax reduction of 20% of the finance costs (or the property profits or adjusted total income, if lower).
The charts (below) indicate the combined effect of the rise in interest rates and tax restriction for a higher-rate taxpayer. The examples estimate average rental yield and property value at 5% and £250,000 respectively, with a 25% deposit and interest-only mortgage of £187,500. The interest rates reflect the two-year rise in average rates already discussed. For illustrative purposes we have kept many figures constant, including allowable property expenses of £2,500 per annum.
These figures highlight that the cash return to the landlord, after tax, will decline from £2,805 before 2017 to a loss of £705 in 2022/23. The impact will be even more acute for additional rate taxpayers and those in the band where the personal allowance is withdrawn.
Before 6 April 2017
At this point in time, tax relief would have been available in full for finance costs. Assuming a mortgage of £187,500 and an interest rate of 2.84%, the finance costs would have amounted to £5,325.
£ |
|
|---|---|
Annual rental income |
12,500 |
Deduction for finance costs |
(5,325) |
Deductible property costs |
(2,500) |
Taxable property income |
4,675 |
Tax position |
£ |
|---|---|
Higher rate income tax on property income (£4,675 @ 40%) |
1,870 |
Net cash position for landlord |
£ |
|---|---|
Annual rental income |
12,500 |
Less: finance costs |
(5,325) |
Less: property costs |
(2,500) |
Less: income tax |
(1,870) |
Net cash |
2,805 |
2020/21 tax year
By this tax year, full tax relief for finance costs had been replaced by a 20% tax reduction for finance costs.
£ |
|
|---|---|
Annual rental income |
12,500 |
Deduction for finance costs |
- |
Deductible property costs |
(2,500) |
Taxable property income |
10,000 |
Tax position |
£ |
|---|---|
Higher rate income tax on property income (£10,000 @ 40%) |
4,000 |
20% tax reduction for finance costs (£5,325 @ 20%) |
1,065 |
Net cash position for landlord |
£ |
|---|---|
Annual rental income |
12,500 |
Less: finance costs |
(5,325) |
Less: property costs |
(2,500) |
Less: income tax (£4,000 - £1,065) |
(2,935) |
Net cash |
1,740 |
2022/23 tax year
As interest rates increase, the impact of the finance cost restriction starts to bite. In this example, assuming a mortgage of £187,500 and an interest rate of 4.47%, the finance costs amount to £8,381.
£ |
|
|---|---|
Annual rental income |
12,500 |
Deduction for finance costs |
- |
Deductible property costs |
(2,500) |
Taxable property income |
10,000 |
Tax position |
£ |
|---|---|
Higher rate income tax on property income (£10,000 @ 40%) |
4,000 |
20% tax reduction for finance costs (£8,381 @ 20%) |
1,676 |
Net cash position for landlord |
£ |
|---|---|
Annual rental income |
12,500 |
Less: finance costs |
(8,381) |
Less: property costs |
(2,500) |
Less: income tax (£4,000 - £1,676) |
(2,324) |
Net cash |
(705) |
Is it time to incorporate?
Since the finance restriction was introduced, many landlords have opted to purchase properties through a company. This is because the corporate tax rate is lower than income tax rates and no restriction applies to tax relief for interest costs. However, for those with an existing property portfolio, the stamp tax and capital gains tax costs of incorporation are often prohibitive.
Heading back to the example, the income tax on the rental income amounts to £2,324 in 2022/23. Even taking account of the planned increase in the corporation tax rate to 25%, the corporation tax bill amounts to only £405. Clearly there will be a tax charge in the future should the value of the property be extracted from the company, or the rental returns distributed. But for many investors, who are looking at property portfolios as a longer-term asset, the cash incentive now means a corporate vehicle is a no-brainer.
Remember, the tax reduction for finance costs is limited to the lower of the finance costs, property profits and adjusted total income. If interest rates increase further, the likelihood of finance costs exceeding one of the other figures increases. In the examples here, finance costs could quite easily outstrip the property profits of £10,000.
So, if the interest rate was 6% in 2023/24, the annual interest cost would be £11,250. The tax reduction would be £2,000 (£10,000 x 20%). The excess unrelieved amount of £1,250 would be carried forward. The net cash position for the landlord is then a loss of £3,250.
Other issues
Rising finance costs and interest rates are not the only costs that are increasing for BTL owners. Other tax measures have also targeted these investors.
Stamp taxes differ in Wales and Scotland, but in England and Northern Ireland, a 3% additional rate applies for an individual who owns more than one property and for residential properties purchased by a company. A 15% rate can apply to residential properties costing more than £500,000 bought by a company, although this rate does not apply if the conditions are met for the property to be used for a property rental business. Similarly, the annual tax on enveloped dwellings should not apply where a company-owned property is let to a third party on a commercial basis and is not, at any time, occupied (or available for occupation) by anyone connected with the owner.
For individual landlords, lettings relief was effectively removed from 6 April 2020. Lettings relief reduces any capital gain on a person’s main residence for periods where it has been let out. From 6 April 2020 this is now only available where the owner has shared occupation with the tenant, regardless of when the letting took place. This will have had a negative impact on those homeowners who let out their home while they moved into a second property or lived abroad prior to April 2020.
Final thoughts
Landlords are facing uncertain times with interest rates at a 14-year high, more increases expected and an increasing tax burden. Even with the tax costs associated with incorporation, could the current climate trigger a serious look at restructuring property portfolios?
About the author
Angela Clegg, Business Tax Manager, ICAEW