I have a client who has a property which has been let for 10 years. She need to raise some money and has been advised by a friend that she would be better taking a mortgage on her home rather than the rental property, but that she could apply the mortgage interest on the loan, up to the value of the property when it was first let, against the rental income. I cannot remember if I have seen this discussed before.
Can she?
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That's right
The way to look at it is that the original value was introduced into the property business, the fact that she's decided only now to use borrowings to back it up is OK.
Note that as well as the value at the time you can top it up with legal fees & stampduty at the time plus any capital expenditure since.
No
She can withdraw capital from the rental business up to the value of the capital she put in - i.e. the value of the property when first let (assuming it was unencumbered). In other words, she can take a mortgage up to that amount on that property, thus reducing the value of the business asset and effectively withdrawing her capital. See here:
http://www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htm
If she takes a mortgage on her home, she is neither borrowing to buy the rental property nor withdrawing capital from the business - as her home isn't a business asset for the rental business - and no relief will be available on the interest.
Cathy
I stand corrected
Sorry RG, I bow to Cathy's superior knowledge and will double check a couple of my own clients !
Edit: Cathy - I think the cases I have come across are where individuals raise loans, with their homes as security, to buy or improve rental properties, which I have always classed as OK, ie doesn't matter how you raise the finance, as long as it's used in the rental business.
What would be interesting is where, because of the drop in value of a rented property or tighter lending criteria, a bank refuese to lend against the rental property but is happy to take the home as security.
Pushing the boundaries!
I have seen it suggested that you can do what is proposed but I can't see how you can justify including on the balance sheet of a property business a loan which isn't secured against an asset of the business and wasn't used to buy a business asset - or even used to buy a personal asset which has become a business asset. There isn't, as far as I can see sufficient relationship between the loan and the business. Taking a loan on the let property is different as the value of the business assets have been reduced reflecting a withdrawal of capital from the business.
However, if anyone else thinks differently - or has persuaded HMRC that it's OK, I'd love to hear about it!
Cathy
@ Paul re edit
That's fine, Paul, as the purpose of the loan is to buy an asset to be used in the business. It's even OK if the purpose was to buy a private asset which becomes a business asset as there is a clear relationship between the loan and the business asset.
Cathy
Extra thoughts
Cathy - there is no doubt that the funding of any business, especially a sole trader, can be muddied between personal & business aspects.
The classic case for me is where, in a standard trade with a healthy capital account, the person's working capital is all tied up in stock, work in progress & debtors leaving little if any cash (or overdraft) with which to both run the business and provide sufficient cash to cover drawings. In such a case it is perfectly acceptable for the trader to get a personal loan injecting all the funds into the business and entering the loan on the balance sheet, even if the first cheque that's written out is to pay drawings or repay some capital.
Similarly, I have a client with 10 rented properties who is always juggling and wheeling & dealing with lenders over the best deals, using the equity in the rented properties and his own home to get decent terms & interest rates. His overall borrowings are well below the initial equity of his rental properties (capital injection) and he will always make sure he has £75K in cash sitting there to snap up a deal. He lives off this business, with monthly drawings as well as lump sums for other personal needs, but, because the rental income is quite often only enough to cover interest and other running costs, much of his drawings can come from this cash ie mortgage monies.
So, I suppose, at the end of the day it is looking at the situation on a case by case basis. In the case of RM's question therefore, I can see both sides of the argument but could imagine a case where someone wanted to release some of their capital from the rental property but where the lender or terms of the loan made it more beneficial from a financial, practical or timing aspect, to have the loan secured on their own home.
In such a case I would certainly consider bringing that loan onto the property business balance sheet, but with a strong health warning to the client.
considering
Hi Paul, It is indeed more economical for her to take the mortgage on her home - she will get a much better rate, which is why this was raised. She is divorcing and in order to keep the rental property she needs to raise finance. How would you give a 'strong health warning' to the client?
RG
As indicated by the exchange of emails above, this is a tricky area and will very much come down to the specific and wider circumstances of each case. The problem is that whilst the basic rules for allowability are the same in both property and non-property businesses the sums tend to be much larger and, let's face it, on a day to day basis a one-property business is not easily comparable to a trade.
Having said that though the business rules do apply and HMRC readily accept that it's not necessary for example that a loan is secured by a business asset (in this case the let property) and so it is OK to have a business loan secured on your personal home. They do however say that loans to fund personal assets or expenses are not allowable, but this is countered, in theory, where a person has business capital and wishes to withdraw it, but with the overriding condition that the business capital account does not go overdrawn, purely because of the drawings.
The first thing I would suggest you do is work through the business interest section of the manual Cathy referred to above, http://www.hmrc.gov.uk/manuals/bimmanual/BIM45650.htm
I don't know whether Cathy has dealt with anything like this but I have not had exactly the same case as you. I have had a similar case where, in order to get a desirable investment property, a client used his own cash to buy it, getting a discount and not having the delay of getting a mortgage approved. This had not been his plan but, as I say, the property was too good to turn down. This then meant he had no cash and so, within 6 months he had organised a mortgage to cover about 75% of the cost I think, thus giving him cash back. To my mind it didn't matter whether the mortgage was secured on the rental property (can't remember) and neither did it matter what he then did with the cash from the mortgage. He was now in the position he could/should have been in had he not have to rush and so I allowed all of the interest.
In purely fact terms your case is very similar however the timescales are different and I would suggest HMRC could argue the prime motive is different. I am bound to wonder whether actually securing the loan on the rental property would actually make any difference to this grey area.
If it were me, I would take further advice (I pay for tax consultancy for borderline or unknown issues) and if I still thought it worth a try I'd go for it but would warn the client that it was risky and open to challenge by HMRC. I would also make sure the white space made reference to the circumstances to give HMRC the opportunity to question or ignore it.