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A quick recap on tax relief for mortgage interest
From 2017 the Government started to make the transition from mortgage interest being a business expenses and receiving full tax relief, to mortgage interest not being a business expense and only receiving 20% tax relief.
The change meant that individuals lost some tax relief on their mortgage interest payments, and an individual’s income was artificially inflated. This had implications for the availability of an individual’s personal allowance, the ability for an individual to make pension contributions and for Child Benefit clawback.
With interest rates rising, landlords face yet another strain on their business.
What is the impact of increased interest rates?
Let us take an example of an individual with the following circumstances: £50,000 of rental income, £6,000 of expenses, and a £650,000 mortgage at a 2% interest rate. Their position is as follows:
| BR taxpayer | HR taxpayer | AR taxpayer | |
| Income | 50,000 | 50,000 | 50,000 |
| Other expenses | (6,000) | (6,000) | (6,000) |
| Interest | (13,000) | (13,000) | (13,000) |
| Commercial profit/(loss) | 31,000 | 31,000 | 31,000 |
| Income | 50,000 | 50,000 | 50,000 |
| Other expenses | (6,000) | (6,000) | (6,000) |
| Profit for tax purposes | 44,000 | 44,000 | 44,000 |
| Marginal rate of tax | 20% | 40% | 45% |
| 8,800 | 17,600 | 19,800 | |
| Tax reducer for mortgage interest | (2,600) | (2,600) | (2,600) |
| Tax liability | 6,200 | 15,000 | 17,200 |
| Commercial profit | 31,000 | 31,000 | 31,000 |
| Tax liability | (6,200) | (15,000) | (17,200) |
| Cash position | 24,800 | 16,000 | 13,800 |
| Tax rate on rental profit | 20% | 48% | 55% |
You can see the effect of the restriction increasing an individual’s overall rate of tax – a 45% taxpayer is actually paying 55% tax on their profits. Many landlords feel that the additional benefits that come with property investment are worth this additional tax liability.
However, with interest rates rising the picture changes dramatically. If we take the above example, but increase the rate of interest to 6% we have the following picture:
| BR taxpayer | HR taxpayer | AR taxpayer | |
| Income | 50,000 | 50,000 | 50,000 |
| Other expenses | (6,000) | (6,000) | (6,000) |
| Interest | (39,000) | (39,000) | (39,000) |
| Commercial profit/(loss) | 5,000 | 5,000 | 5,000 |
| Income | 50,000 | 50,000 | 50,000 |
| Other expenses | (6,000) | (6,000) | (6,000) |
| Profit for tax purposes | 44,000 | 44,000 | 44,000 |
| Marginal rate of tax | 20% | 40% | 45% |
| 8,800 | 17,600 | 19,800 | |
| Tax reducer for mortgage interest | (7,800) | (7,800) | (7,800) |
| Tax liability | 1,000 | 9,800 | 12,000 |
| Commercial profit | 5,000 | 5,000 | 5,000 |
| Tax liability | (1,000) | (9,800) | (12,000) |
| Cash position | 4,000 | (4,800) | (7,000) |
| Tax rate on rental profit | 20% | 196% | 240% |
An increase in interest rates will leave landlords with very high tax bills and in a cash negative position.
Action to be taken
Landlords would be wise to review their affairs. Points to note: What are the terms of existing mortgages? When are fixed term mortgages coming to an end? Are tenancies secure and tenants reliable?
Ultimately, what is the commercial reality of the business and is this sustainable? If it is not sustainable, what options are there?
Diversifying
What is the impact of selling properties, repaying debt, paying the associated tax liabilities, and reinvesting the remaining funds? Does this approach offer a better strategy for long-term objectives than persevering in an increasingly difficult property market?
If we can help with estimated capital gains tax computations, or with introductions to financial advisers, please let us know.
Income sharing
Sharing income with your spouse is uncontentious tax planning in most circumstances, and it is always worth exploring whether a couple’s basic rate bands and allowances are being used effectively.
Gifts to spouses are free from capital gains tax. Income arising from assets owned jointly by spouses is shared equally for tax purposes, even where ownership is not 50:50; it is therefore possible to gift a small proportion of a property and have both spouses taxed on 50% of the income arising.
Sharing income with other family members, such as children, is more problematic. There are capital gains tax implications, and the commercial reality of a gift should never be ignored.
Airbnb and short-term lets
The tax legislation has a ‘furnished holiday lets’ or ‘FHL’ regime. There are tax benefits to the FHL regime, the reliefs are far more generous than those available to a traditional landlord. For example, a full deduction for mortgage interest is allowed. A landlord will therefore not be burdened with the high tax rates described above. Further, it is possible to claim tax relief for all furniture, appliances, utensils and everything else associated with furnishing a property for letting.
A property qualifies as an FHL if, in a tax year, that property is available for short-term lets for 210 days, is let on a short-term basis for 105 days, and the number of long-term lets is fewer than 155 days. A short-term let is one that is for a continuous period of 31 days or fewer, with longer-term lets being more than this count.
The risks associated with holiday lets should not be overlooked. A significant investment of capital may be necessary to upgrade properties to the required standard for short-term lettings. The high turnover of guests and additional management require greater time investment. As a result of Airbnb making the FHL market more accessible and the associated tax incentives, the market is becoming increasingly saturated. In addition, if the strict conditions above are not met, for example if it was not possible to find the required number of lettings, the tax benefits will not be available.
Incorporation
The incorporation of a property business is often discussed in terms of being a ‘silver bullet’ to fix a landlord’s tax woes. This, however, is not the case.
The act of incorporating a property portfolio tax efficiently is extremely difficult to achieve. There is a significant exposure to both capital gains tax and stamp duty land tax to navigate, and if this is not done carefully substantial tax charges can arise. The technicalities of this are outside the scope of this article. Services offered by businesses claiming to guarantee a tax efficient incorporation should be approached with extreme caution. Indeed, we have recently come across clients who are being told to do things that were effectively outlawed by legislation five years ago.
Companies are no longer as tax efficient as they used to be. We have seen dividend tax rates rise significantly in recent years, with the higher rate of dividend tax rising from 25% to 33.75%. The effect of this is that a higher rate taxpayer, who should pay tax at 40%, is subject to an overall rate of tax of 46.3% once corporation tax and dividend taxes are considered.
Further, banks are more cautious when lending to a company compared to an individual. It may be that a bank requires personal guarantees, and it is likely that a bank will charge higher rates of interest.
There are advantages to incorporating a property business, most notably it is more efficient to build a property business within a company than personally, with low rates of corporation tax facilitating reinvestment. It is not, however, a solution for everyone.
If you are considering sale in the near future incorporation may not be the correct thing.
Conclusion
The Government has made the life of landlords increasingly difficult in recent years, and the prospect of increased interest rates will put additional strain on property businesses. There are options available to landlords, but none of them are easy and many landlords may consider that they are not solutions. If you would like to discuss any of the above, please let us know.
