Loan interest deductible from rental income?

Loan interest deductible from rental income?

Didn't find your answer?

Client owns his own home (home #1). Current value £1m. Originally took out a mortgage of £300k to purchase home #1 but mortgage now paid off.

Now intends to buy second home (home #2) for £1.6m. Will borrow £1.5m against security of both properties.

Home #1 will then be let out and he will move into home #2.

What proportion of the interest on the £1.6m mortgage is deductible from the rental income of home #1?

I realise that similar questions come up on AW from time to time but I never end up clear on the principle!

Many thanks.

Replies (21)

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By User deleted
26th Nov 2013 18:06

It will probably depend on the paperwork ...

... but I'd suggest somewhere in the region of 0% to 62.5%

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Replying to WhichTyler:
Red Leader
By Red Leader
26th Nov 2013 18:14

@BKD

Your answer is the sort I sometimes end up giving to clients - in other words, it's absolutely correct but the phrase "concrete parachute" comes to mind!

I think I had  already stumbled to the same answer before I posted. Any ideas on what the paperwork should look like? Foolscap or A4? No seriously, can you flesh it out a bit more?

Cheers.

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By User deleted
26th Nov 2013 18:32

The difficulty as I see it ...

... is the dual security. Presumably one will have priority over the other - in other words, in event of default, which property will the bank go after first? In the absence of any ranking, I imagine that it would be the rental property but not necessarily. The lender may want security primarily over the property being purchased, with a second security over the BTL as a precaution. I would have thought that to be the more likely scenario, in which case I would expect HMRC to argue that no interest is deductible.

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Teignmouth
By Paul Scholes
26th Nov 2013 21:48

Don't think the security aspect matters

If you borrow £X to buy an asset for your business, it doesn't matter whether there is no security or whether security is given over the asset itself or your house, the interest is all allowed. Same here.

You can organise your financial affairs in the way that suits you best and so if you introduce a £1M asset into your property business, you may also introduce a loan up to that value.  This would also be the case if they had bought is cash today then borrowed in a years time to release capital, the fact it's all taking place at the same time, makes it easier to do.

So I'd claim 2/3rds

 

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By User deleted
26th Nov 2013 22:14

I disagree, Paul

Whilst this is only the opinion of one Inspector (and would therefore need to be tested at Tribunal) HMRC's view of such matters was recently relayed to me. They accept that whilst not exactly following the example in their Manual, if an individual borrows money that is ostensibly for a non-rental business purpose (eg buying a new home) then the interest can be allowed, provided that the debt is secured over business property. Conversely, they will also allow interest where borrowing is taken to buy an asset that is used in the rental business but secured on a non-business asset. What they will not accept is borrowing raised to buy a non-business asset and that is not secured on any business asset - ie borrowing that has no link with the business.

Otherwise we're back at the hypothetical case that I've often referred to - a sole trader with a healthy capital account could obtain interest relief on a mortgage on his new home simply by putting a fictional journal entry through his sole trade accounts.

I therefore think that the nature of the security may be crucial here.

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Stepurhan
By stepurhan
27th Nov 2013 07:59

Order of purchase is the issue

The problem is that it is the home that is currently owned that is being let out, not the one acquired. The loan is therefore being taken out to purchase a home for the client, not a business asset. The business asset is only "acquired" insofar as it becomes available to rent because the client will now have somewhere else to live. This is where BKD is coming from I think.

Depending on how soon the old property is let out, a PPR election may also be advisable here, though that is a separate issue of course.

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By User deleted
27th Nov 2013 08:28

To clarify, Stepurhan

If the new loan were secured entirely and solely on the existing (BTL) property HMRC have confirmed (well, at least one Inspector has) that relief would be allowed in respect of the loan taken out to buy the new home. Problem here is that the value of the BTL is not sufficient to cover the new mortgage. I think it would be unusual for a lender to take a split security - far more likely to take full security againsnt the property being purchased with a second security over the BTL as a belt-and-braces approach.

Given HMRC's advice on this, one might argue that because there is security over the BTL, albeit a secondary security, then relief should be allowed. I've never come across this situation, though, so have no idea how HMRC would in fact react - but my suspicion is that they would argue that the primary security over the new home would preclude relief. We can debate until we're blue in the face what the correct treatment should be, but until it's actually put in front of HMRC I don't think anyone can say with any certainty what amount of relief will be allowable.

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Stepurhan
By stepurhan
27th Nov 2013 11:55

Marshall your arguments.

WIth the loan being for purchasing a private property and assuming no security on the Buy to Let, you definitely have an uphill struggle. However, the buy to let would not be possible without the loan, because the property would not be available to let, so there is an argument there. If you feel up to facing an HMRC challenge on the issue, put notes together on your arguments and make the claim. As BKD says, there is some uncertainty there, and one inspector's opinion on the matter is not the same as a Tribunal decision.

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By ccassociates
27th Nov 2013 12:10

I'm with Paul

The house would not be available to let if it was not for the finance, threfore the asset and the liability are introduced at the same time.

There are too many Inspectors who think they can interperate the rules as they see fit, the facts are that the loan equivalent to the value of the property when first let is allowable against the rental income. Why should anyone have to go to tribunal on this?

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By User deleted
27th Nov 2013 13:36

Two points

Who said that the BTL would not be available without the loan finance? If the bank had declined, the individual could have rented a new home instead, or moved in with his parents, or camped in a field. I think it is far too tenuous to argue that the property has become available to let simply because the individual has been able to obtain funds to buy another property to live in. The underlying principle is that there must be some business purpose of the borrowing. This means that the money must be used either for the purpose of buying a business asset or must be secured on business assets. If it is neither, I suspect that you will not get very far in Tribunal (though I'm not saying that you shouldn't try).

So, ccassociates - you say that it is matter of fact that the loan equivalent to the value of the property is available for relief. I would suggest that that is your opinion rather than a matter of fact. But let's not split hairs - assuming that you are correct, presumably you will concede that in the case of a sole trader with a healthy capital account and who wishes to borrow to buy a new house (with the mortgage secured solely on the house and the cash going nowhere near the business) you'd be more than happy to put a fictional journal - Dr Drawings Cr Loan - through the accounts, and claim the tax relief? I'll take a non-answer as "no".

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Replying to KevinMcC:
Stepurhan
By stepurhan
27th Nov 2013 14:35

Not quite the same

BKD wrote:
Presumably you will concede that in the case of a sole trader with a healthy capital account and who wishes to borrow to buy a new house (with the mortgage secured solely on the house and the cash going nowhere near the business) you'd be more than happy to put a fictional journal - Dr Drawings Cr Loan - through the accounts, and claim the tax relief? I'll take a non-answer as "no".
Though I can see the merit of your overall argument, making claiming interest an uphill struggle at best, this is not equivalent. In the situation being queried, the client is introducing an asset (the old property) at the same time as the loan (the mortgage) so there is no net drawing from the BTL business and no change in the overall asset position. The argument for claiming the interest is that the loan is the "cost" to the business, as separate from the individual, for acquiring the asset. If the balancing entry was client drawings  instead, there would be no such asset acquired and the business assets would go down.
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By stratty
27th Nov 2013 14:19

Mortgage Interest

Why would any of the interest be allowable when the mortgage is for the client's main residence?

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By User deleted
27th Nov 2013 14:25

Already answered, Stratty

But I'll repeat. Interest is relievable if the loan is for business purposes. HMRC accept that "business purpose" can include security over a business asset for borrowing used to finance a non-business asset - and vice versa. What they do not accept is borrowing that is used neither for financing business assets nor which is secured over business assets. They may be right, they may be wrong, but it seems a perfectly reasonable approach to me. Good luck to anyone that tries to claim tax relief in the 3rd scenario.

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By User deleted
27th Nov 2013 14:52

I disagree, stepurhan

In order to obtain interest relief you must have sufficient capital to cover the amount "drawn" as a consequence of the loan. Although the introduction of the BTL and mortgage may be simultaneous, there needs to be a recognition of the capital introduced. Whilst not identical in terms of transactions and timing, I consider the principle in the sole trader case to be the same.

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Replying to KevinMcC:
Stepurhan
By stepurhan
27th Nov 2013 21:18

Linked transactions

BKD wrote:
In order to obtain interest relief you must have sufficient capital to cover the amount "drawn" as a consequence of the loan. Although the introduction of the BTL and mortgage may be simultaneous, there needs to be a recognition of the capital introduced. Whilst not identical in terms of transactions and timing, I consider the principle in the sole trader case to be the same.
I suspect that we will have to agree to disagree on this, but I would say that the introduction of the house and loan at the same time are linked. This is because the businessman is only introducing the capital (the house) because of the loan that allows him to live elsewhere (the mortgage). By contrast the large capital account might be retained profits and hence not even be funds introduced by the trader at all. There is no link between those funds and the "drawings" of the loan. This is precisely why I focused on the net business assets not changing in the house-introducing scenario.

Claiming the interest relies on establishing the link between the two actions (introducing the house and taking out the loan). Here the fact that there is no direct link between the loan and the business creates a problem. I also accept that your argument that the trader could simply have rented or made other arrangements will also carry some weight for HMRC saying no. I'd still be interested in the Tribunal take on it.

As an aside, say a sole trader took out a loan within the business, and secured it on business assets. If their capital account is large enough to fund a house purchase, there are probably some reasonable assets in there so not implausible. If they then took cash out to fund a house purchase, but keeping their capital account in credit, would the interest on that loan still be claimable? After all, the accounting effect is pretty much the same as them "introducing" an external loan.

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By stratty
27th Nov 2013 14:54

"HMRC accept that "business

"HMRC accept that "business purpose" can include security over a business asset for borrowing used to finance a non-business asset - and vice versa"

I do not understand why HMRC would let you have the interest relief when you are using the security for personal benefit so I find this very intriguing.  Will have to do a bit more research on it.

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Replying to Francois Badenhorst:
Red Leader
By Red Leader
27th Nov 2013 17:22

@stratty

Probably best to start with example 2 in BIM45650.

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The triggle is a distant cousin of the squonk (pictured)
By Triggle
27th Nov 2013 18:13

Or more specifically Example 2 at:

http://www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htm

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Teignmouth
By Paul Scholes
27th Nov 2013 18:18

Has to be worth a go

Thanks BKD for the update, it's always valuable to hear of examples of practice where the legislation is grey.

For that reason however (ie greyness) I'd go with Basil's advice of making full disclosure, but in this case I'd claim the full interest I regarded as justifiable and warn the client that it might well be open to challenge and the extra tax payable.

As far as business purpose goes, I am strangely in a similar situation.  Using the numbers above, shall I just move home, selling up for the £1M and thus only needing to borrow £0.5M to buy Home #2?  Or, because rental rates are so good, and I don't want to waste money on estate agents & legal fees, shall I keep Home #1 to rent out, thus having to increase my borrowing to £1.5M?

If I go for option 2 the consequence is extra borrowing of £1M and, as now forewarned by BKD, I'd make sure Home #1 was used as security.

 

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By User deleted
27th Nov 2013 21:57

Capital

As an aside, say a sole trader took out a loan within the business, and secured it on business assets. If their capital account is large enough to fund a house purchase, there are probably some reasonable assets in there so not implausible. If they then took cash out to fund a house purchase, but keeping their capital account in credit, would the interest on that loan still be claimable? After all, the accounting effect is pretty much the same as them "introducing" an external loan.

I would say yes.

Because it's not about linking transactions, it's all about withdrawing capital from the business. Whether that capital is withdrawn immediately it is created or 25 years later, it really doesn't matter.

This is because the businessman is only introducing the capital (the house) because of the loan that allows him to live elsewhere (the mortgage)

The point that you are missing is that if the mortgage is unrelated to the business - being neither for the purchase of a business asset nor being secured on business property then HMRC's view is that the mortgage has no right to be anywhere near the business balance sheet. As I said earlier, I believe that argument that the loan should be recognised just because it frees up the property to be let is too tenuous.

It's not a case of agreeing to disagree - I'm not saying that HMRC are right or wrong on this, simply relaying what they have told me that their approach is.

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Replying to SteveHa:
Stepurhan
By stepurhan
28th Nov 2013 07:59

Agreeing to disagree

BKD wrote:
The point that you are missing is that if the mortgage is unrelated to the business - being neither for the purchase of a business asset nor being secured on business property then HMRC's view is that the mortgage has no right to be anywhere near the business balance sheet. As I said earlier, I believe that argument that the loan should be recognised just because it frees up the property to be let is too tenuous.

It's not a case of agreeing to disagree - I'm not saying that HMRC are right or wrong on this, simply relaying what they have told me that their approach is.

This is the point where I think we will have to agree to disagree. I fully understand that a business asset is not being purchased, nor is one going to be secured. I also understand that HMRC's view is that this means the loan doesn't belong on the balance sheet. Our difference of opinion is over whether to accept HMRC are correct in this assertion. For all your stating you not saying that HMRC are right or wrong on this, you appear to be accepting this whereas I believe there is an argument to be made, albeit a quite difficult one in the circumstances.

But, as is often the case, some planning on the structure of the arrangements would resolve much of the uncertainty. Making sure that the let property is the one secured first would largely deal with the problem. Just like the withdrawal of a large capital account, two different ways of achieving the same result can make a huge difference to the deductibility of the tax.

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