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The changing tax landscape for buy to let landlords

As buy to let properties have been a hot topic as of late, Sue Moore of the ICAEW Tax Faculty explains the rules to restrict finance costs and their consequences.

Tax landscapeThe hot topic for the last few Budget statements has been buy to let (BTL) properties, with tax changes being introduced as part of the policy to discourage BTL landlords and allow first-time buyers to get their foot on the property ladder. BTL landlords and first-time buyers are generally looking in the same property category and all too often the first-time buyer is pipped at the post in the race to buy.

Landlord deterrents

The additional 3% stamp duty land tax serves to deter BTL landlords coming into the market while the restriction on tax relief for finance costs being phased in from 6 April 2017 impacts on existing BTL landlords. The first monetary impact of the income tax change will hit BTL landlords in their 2017/18 self assessment and the tax liability to be paid by 31 January 2019.

For those landlords who decide to sell their BTL property, there are no concessions on the capital gains tax (CGT) payable; the rate is at the higher rates of 18% or 28% for gains falling into the basic rate or higher/additional rate tax bands. This could leave highly geared landlords in a tricky predicament; the income tax relief restriction on the interest payable may turn the rental business into a loss-making venture, forcing them to sell, but due to the high gearing they may have insufficient free cash after the sale to pay the CGT. It could be worse! For sales after April 2020 it is proposed that the CGT will be payable within 30 days of the disposal, leaving no time to release funds from elsewhere after the sale.

Schedule A income tax rules

Prior to 1998/99, under the Schedule A rules interest paid on a loan to buy a rental property was not deductible in the rental profit and loss account; it was allowed as a charge against income and so could be restricted if there was insufficient income left in charge to tax to cover the interest. As part of the simplification for self assessment, the rules for calculating rental profits were aligned with the rules for trades and businesses and so interest could be deducted in the profit and loss account.

A knock-on effect from this alignment was that landlords could borrow funds up to the value of the property when it was first placed in the rental business and claim tax relief on the interest paid. Previously landlords were restricted to the original sum borrowed, and when any part was repaid that set a new lower limit for tax allowable interest.

A change to HMRC guidance in April 2017 to explain the finance cost restrictions changed the position for loan increases to withdraw capital from the business, saying that interest relief is only allowed as long as the additional loan is wholly and exclusively for the purposes of the letting business. Previously it said: 'If you increase your mortgage loan on your buy to let property you can also treat interest on the additional loan as a revenue expense but only up to the capital value of the property when it was brought into your letting business' – a subtle difference. The associated example (which has now been removed) illustrated this point. The Business Income Manual at BIM45700 still has the original guidance and the example. The Tax Faculty together with CIOT is querying the change of wording with HMRC.

Finance cost tax relief restrictions

The finance cost restrictions apply from April 2017. In essence the changes are to restrict tax relief to the basic rate of income tax only and not give relief at the higher or additional rate of tax so that, as previously, the interest paid cannot be deducted in the rental profit calculation. But there are some other tax consequences, as will be seen.

The legislation restricting how much of the business’s finance costs can be claimed against rental income is in s272A, Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005). The restriction is introduced over four years with 25% being restricted in 2017/18, 50% in 2018/19, 75% in 2019/20 and 100% in 2020/21. Finance costs include the interest payable and the costs of obtaining the finance.

The restricted amount is potentially eligible for the basic rate deduction. The basic rate deduction (s274A, ITTOIA 2005) reduces the tax liability; it is 20% (or the basic rate of tax if different) of the lowest of:

  1. The finance cost restricted in the current year plus any restricted finance cost brought forward.
  2. The taxable profits of the rental business after deducting any losses brought forward.
  3. The adjusted total income for the year, calculated as adjusted net income from step 2 in s23, Income Tax Act 2007 less savings income, dividend income, personal allowance and blind person’s allowance.

If either 2 or 3 are brought into play, the excess finance cost restricted (that is, the amount calculated at 1 less the amount used from 2 or 3 to calculate the restriction) is carried forward to the next year.

Examples 1 and 2 show how the restriction works.

Example 1: Meghan

 

2016/17

2017/18

 

£

£

Salary

80,000

80,000

Rents before finance costs

70,000

70,000

Finance costs (note 1)

(50,000)

(37,500)

Personal allowance (note 2)

(11,000)

(5,250)

Taxable

89,000

107,250

Tax payable before interest credit

29,200

36,200

Credit under s274A (note 3)

 

(2,500)

Net liability

29,200

33,700

  1. The finance cost in the profits calculation is restricted by 25% to £37,500.
  2. As the individual’s taxable income exceeds £100,000 (it is £112,500) the personal allowance is restricted to £5,250 (£11,500 - (12,500/2)).
  3. The credit is calculated as 20% of the lowest of:

The restricted finance cost – £12,500

Profits of the rental business – £32,500

Adjusted total income – £107,250 (£80,000 + 70,000 - 37,500 - 5,250)

Therefore the credit is 20% of £12,500 = £2,500

Example 2: Harry

 

2016/17

2017/18

 

£

£

Interest

26,000

26,000

Rents before finance costs

17,000

17,000

Finance costs (note 1)

(6,000)

(4,500)

Personal allowance

(11,000)

(11,500)

Taxable

26,000

27,000

Tax payable before interest credit

4,000

4,400

Credit under s274A (note 2)

 

(200)

Net liability

4,000

4,200

  1. The finance cost in the profits calculation is restricted by 25% to £4,500.
  2. The credit is calculated as 20% of the lowest of:

The restricted finance cost – £1,500

Profits of the rental business – £12,500

Adjusted total income – £1,000 (£17,000 - 4,500 - 11,500)

Therefore the credit is 20% of £1,000 = £200

The excess finance cost of £500 (£1,500 - 1,000) is carried forward

Other consequences

Meghan (example 1) has lost part of her personal allowance as the finance cost restriction has pushed her income over the £100,000 threshold. Harry (example 2) has lost £1,000 of the 0% savings rate band. Other consequences that may result from the finance cost restriction include:

  • Loss or restriction of child benefit because the high income child benefit charge threshold (£50,000/£60,000) is crossed.
  • Loss or reduction of the personal savings allowance (£1,000/£500/£0) as the taxpayer moves from basic rate to higher rate or higher rate to additional rate.
  • Excess pension charge because the income without the benefit of the interest relief exceeds £150,000 causing allowable pension contributions to be reduced from £40,000.

For Harry in example 2, the tax credit is based on the adjusted net income, so the excess finance costs restricted are carried forward. As Harry receives his income from investments the impact of the finance cost restrictions is even greater as the adjusted total income is so low.

When considering a possible reduction to payments on account for 2018/19 you will need to remember that the finance cost restriction will be 50% not 25%.

The restriction has to be calculated for each property business separately. UK and overseas property rentals are separate businesses but so are a personally-owned property business and a share in a property business. This could result in the basic rate deduction being limited by a lack of rental income for one rental business, whereas if the letting activity could be looked at as a whole there would be no limitation.

Mixed use

Where a property is in mixed use, say a shop with a flat above, but with just one mortgage, the finance costs are only restricted for the residential part of the property. There is no restriction on finance costs for commercial property, which includes furnished holiday lets. The split of the finance cost between the two parts of the property has to be done on a just and reasonable basis. The Property Income Manual at PIM2056 gives different examples using different bases for the split: square footage, rent received and how the loan is spent.

Trusts and estates

The effect of the finance cost restrictions on trusts depends on whether it is an interest in possession trust or a discretionary trust.

For an interest in possession trust the trustees calculate and account for the tax payable using the allowed portion of finance costs: 75% for 2017/18, 50% for 2018/19, 25% for 2019/20 and 0% thereafter. The beneficiary can claim the basic rate deduction which is calculated in just the same way as if they owned and rented out a property. The beneficiary will need to know the amount of finance cost restricted and the profit of the rental business relative to their share of the trust in order to calculate the level of the deduction.

The same rule applies to a beneficiary of rental property, or a share of a rental property, from a deceased’s estate. The personal representatives are responsible for the tax on the rental income with just the restricted finance costs deducted and the beneficiary makes the claim for the basic rate deduction.

The same rule applies to a beneficiary of rental property, or a share of a rental property, from a deceased’s estate. The personal representatives are responsible for the tax on the rental income with just the restricted finance costs deducted and the beneficiary makes the claim for the basic rate deduction.

If the trust is a discretionary trust, the trustees make the claim for the basic rate deduction; it is calculated in just the same way as for an individual. If the rental income is the only income of a discretionary trust it is possible that the trust may become ‘bankrupt’, particularly if it is highly geared. This is because the interest still has to be paid even though there is no tax relief for it. See example 3:  

Example 3: sussex discretionary trust

 

2016/17

2020/21

 

£

£

Rental income before finance costs

10,000

10,000

Finance costs

7,500

 

Taxable rental income

2,500

10,000

Tax payable before interest credit

875

4,250

Credit under s274B (note 1)

 

1,500

Net liability

875

2,750

Cash position (note 2)

1,625

(250)

  1. The credit is calculated as 20% of the lower of:

    The restricted finance cost – £7,500
    Profits of the rental business – £10,000

    Therefore the credit is 20% of £7,500 = £1,500
  2. The cash position is the net rental income of £2,500 less tax payable.

Conclusion

As with so many tax measures, what starts as a simple premise – to restrict tax relief on interest to basic rate tax – becomes an incredible compliance burden with several (probably) unintended consequences.

Some of these topics, plus additional ones, were covered in the property tax webinar broadcast on 9 July 2018 and still available on catch-up for Tax Faculty members.

We have also published an updated version of TAXguide 01/17 on property letting.

About the author
Sue Moore is a technical manager with responsibility for private client tax matters in the ICAEW Tax Faculty