From 6 April 2017, landlords are no longer be able to deduct all of their finance costs from their property income. As an alternative, they will receive a basic rate reduction from their income tax liability for their finance costs.
Finance costs include:
- Interest and other finance costs on loans taken for a property business which involves the letting of residential properties.
- Loans that are taken wholly for commercial properties and furnished holiday letting business are not affected.
- Any payments that are equivalent to interest related to loan
- Any incidental costs incurred when obtaining a loan such as fees or commission payments. This also includes legal expenses and valuation fees.
The restriction will apply as follows:
Year | Deductible | Reducer |
2017/18 | 75% | 25% |
2018/19 | 50% | 50% |
2019/20 | 25% | 75% |
2020/21 | 0% | 100% |
The changes only apply to individuals, joint owners and partners. It does not apply to limited companies but applies to individuals with high gearing.
Examples:
Linda has employment income of £50,000 in 2017/18. The property income before interest is £12,000 and mortgage interest is £3,000. The non-deductible interest is 25% of £3,000 which is £750.
£ | |
Employment Income | 50,000 |
Rental Income (12,000 – 2,250) | 9,750 |
59,750 | |
Personal Allowances | (11,500) |
Taxable Income | 48,250 |
Basic rate at 20% | 6,700 |
Higher rate at 40% | 5,900 |
12,600 | |
Less interest relief at 20% on £750* | (150) |
Net Tax Liability | 12,450 |
*Lower of rental income (£9,750), adjusted total income (£48,250) and disallowed property finance cost (£750)
Jorge has employment income of £20,000 in 2017/18. His property income before interest is £2,800 and mortgage interest is £3,500. He has property losses brought forward of £3,000.
The non-deductible interest is 25% of £3,500 which is £875.
£ | |
Employment Income | 20,000 |
Rental Income (2,800-2,625-175 (loss relief)) | 0 |
59,750 | |
Personal Allowances | (11,500) |
Taxable Income | 8,500 |
Basic rate at 20% | 1,700 |
6,800 | |
Less interest relief at 20% on £0* | (0) |
Net Tax Liability | 1,700 |
*Lower of rental income (£0), adjusted total income (£8,500) and disallowed property finance cost (875)
- Interest carried forward to 2018/19 (£875-0)
- Property losses carried forward to 2018/19 (£3,000-£175)
Individuals with high gearing should consider to incorporate in order to minimise the impact of the new property legislation.
Tax implications for clients who rely on rental surplus for income
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Paula who is a higher rate taxpayer has a property portfolio with a market value of £900,000 and borrowings of £675,000 at 2%. Her net rental yield is 4% and he relies on the rental surplus for income.
Individual
2017/18 | 2018/19 | 2019/20 | 2020/21 | |
Net rental income (4%) | 36,000 | 36,000 | 36,000 | 36,000 |
Finance costs allowed | Â (10,125) | Â (6,750) | (3,375) | Nil |
Rental Profit | 25,875 | 29,250 | 32,625 | 36,000 |
Tax at 40% | (10,350) | (11,700) | (13,050) | (14,400) |
Tax reducer | 675 | 1,350 | 2,025 | 2,700 |
Post tax income | 12,825 | 12,150 | 11,475 | 10,800 |
Corporate
2017/18 | 2018/19 | 2019/20 | 2020/21 | |
Net rental income (4%) | 36,000 | 36,000 | 36,000 | 36,000 |
Finance costs allowed | Â (13,500) | (13,500) | (13,500) | (13,500) |
Rental Profit | 22,500 | 22,500 | 22,500 | 22,500 |
Corporation Tax | (4,275) | (4,275) | (4,275) | (3,825) |
Dividend | 18,225 | 18,225 | 18,225 | 18,675 |
Post tax dividend | 12,302 | 12,302 | 12,302 | 12,605 |
Corporate saving | (523) | 152 | 827 | 1,806 |
Tax implication for clients that invest for capital growth reasons
Harvey and Donna are married. They both run a substantial rental property business. They each spend 35 hours a week managing the business.
2016/17 | 2020/21 | |
Gross rents | 500,000 | 500,000 |
Repairs and other tax-deductible costs | 150,000 | 150,000 |
Interest on mortgage | 300,000 | 0 |
Net rental profit | 50,000 | 350,000 |
Personal allowances for both of them | 22,000 | 0 |
Taxable income | 28,000 | 350,000 |
Basic rate tax for both of them | 5,600 | 15,000 |
Tax at 40% | 0 | 90,000 |
Tax at 45% | 0 | 22,500 |
127,500 | ||
Less interest relief at 20% on £300,000 | 0 | (60,000) |
Net tax liability on rental income | 5,600 | 67,500 |
Tax increase | 61,900 | |
Effective rate on ‘real’ rental profit | 11.2% | 135% |
In conclusion, transferring an existing rental business to a limited company might not be the best option for Paula. However, it might be best for Harvey and Donna to consider incorporating.
If you have the same circumstances as the above, please don’t hesitate to contact us on 01772 788200 or email info@taxexpert.co.uk for professional advice.