The forthcoming restriction on tax relief for interest on property-related loans: down from the taxpayer’s marginal tax rate to 20%, has been misunderstood by some landlords, says Rebecca Cave.
The restriction of financing costs for individual landlords of residential property is not a simple reduction in tax rate, but a change from a deduction of interest, to a relief that reduces the tax payable. On Budget day Rebecca Benneyworth provided examples of Osborne’s planned reforms, which illustrate how a landlord with a substantial property portfolio could pay tax on 144% on the accounting profit from his lettings business.
The example below shows how a landlord who makes a loss from letting will pay income tax in 2020/21. Such a position is obviously unsustainable, so a change in the lettings business will be required, as discussed below.
Helen is a single parent who earns £25,000. She is entitled to child benefit and pays tax at the basic rate. She lets out her former family home for £34,000, and rents a small flat. The let property has a large mortgage attached so the deductible interest is £36,000. Helen thinks she won’t be affected by the Summer Budget changes as her marginal tax rate in 2016/17 is only 20%.
Her income remains constant, but in 2020/21 her personal allowance is assumed to be £12,500, and the basic rate band: £37,500. However, in that year all of the interest she pays on her let property mortgage is disallowed as a deduction, and instead she receives a tax credit to set against her tax bill.
|Total net income||25,000||59,000|
|Basic rate band limit||32,000||37,500|
|Property loss carried forward:||(2,000)|
|Tax charged @ 20%||2,800||7,500|
|Tax charged @ 40%||-||3,600|
|Tax credit on interest at 20%||(6,800)|
|Total tax payable:||2,800||4,300|
In 2020/21 Helen is a higher rate taxpayer and she loses most of her child benefit because her total income is over £50,000. The tax credit is calculated as 20% of the lower of:
Finance costs not deducted from income (£36,000)
Profits of the property business (£34,000)
Total income exceeding allowances (46,500)
Her lettings business has made an accounting loss of £2,000, but she pays tax of £4,300 of which £2,500 is deducted under PAYE. As her actual finance costs are £36,000 she will be able to carry forward a tax credit of £400 (20% x £2000) to set-off in a later year.
Helen has little choice but to sell her only let property as she has no other resources from which to reduce her borrowings. Other landlords may be able to sell part of their property portfolio, or restructure their lettings business in one of the following directions:
sell residential property and reinvest in commercial buildings
let the residential property as furnished holiday lettings
transfer the properties into a company.
Any of those options will allow a full deduction of interest and other finance costs from the rents received, but the transition will involve CGT and SDLT (LBTT in Scotland) costs. Also the mortgage provider must co-operate with the transfer of loans to a company, and it may require higher rates of interest on a corporate loan.
The sale of the properties, or transfer into a company controlled by the individual, will generate capital gains. CGT will be due unless those gains can be covered by a relief, or deferred using EIS or SITR (social investment tax relief). An investment under SEIS can also be used to exempt up to £50,000 of gain a year, where the maximum permitted (£100,000) is invested in SEIS shares.
Most CGT reliefs (entrepreneurs’, business asset roll-over, hold-over for gifts) can’t be used for gains made within a property letting business, as letting is not regarded as a “trading business”.
Where there are a small number of properties carrying relatively low gains those could be transferred or sold gradually, and the gains covered by the taxpayer’s annual exemption for each year (£11,100 for 2015/16). Where a property is held in joint names the annual exemption of both owners can be set against their proportion of the gain.
If the entire property lettings business is transferred to a company in one go, in return for shares, incorporation relief (TCGA 1992, s 162) may be available to roll the gains into the value of those shares. Incorporation relief can apply to a significant property lettings business, as determined in the EM Ramsay case. No claim is required as incorporation relief is applied automatically if all the conditions are met, but it would be advisable to make a full disclosure on the tax return for the relevant year.
Where the properties are transferred to a company, that company will have to find the funds to pay the SDLT or LBTT charges.
Where the property lettings business has been carried on by a family partnership there may be relief from SDLT / LBTT on the incorporation of that partnership. There is also an averaging relief that can be used to reduce the SDLT when there is a acquisition of multiple dwellings (FA 2003, Sch 6B).
Specialist SDLT/ LBTT advice will be required in all cases. Note: the anti-avoidance rules for LBTT in Scotland are different to those operating for SDLT in the rest of the UK.
Rebecca Cave is the author of Capital Gains Reliefs for SMEs and Entrepreneurs’ 2015/16.