How the restriction of relief on BTL mortgage interest will affect landlords

Analysis and examples of how the restriction of relief on buy to let mortgage interest will affect landlords.

By now I am sure you are all aware of the buy to let “bombshell” within the Chancellor's Summer Budget - the proposal to allow income tax relief on BTL finance costs at the basic rate of tax only - but I thought it might be helpful to show how this will affect the net (after tax) returns to landlords.  

At this stage this is just a “Policy Paper” and I am sure there will be considerable debate with interested parties before this is implemented.  However, for now we have to assume that it will be implemented as proposed starting in 2017/18.

So the good news is that for the next 1.75 years there is no change in the buy to let mortgage interest relief although a separate measure will get rid of the 10% “Wear and Tear” tax allowance for furnished lettings with effect from April 2016.

In looking at the impact of the proposals for interest relief I shall consider only the situation once the proposed measures come into effect fully in 2020/21 – during the preceding three years there is a “tapered” introduction of the measures.  For the sake of easy arithmetic I shall assume that in 2020/21 the personal tax allowance is £12,000 and the basic rate band is £38,000, meaning that the higher rate band starts at £50,000.

Three examples of how it works
So let us consider three examples of somebody who owns a property worth say, £250,000 receiving a rent of £17,000 before letting and other costs of £2,000 and who has a mortgage of £180,000 with an interest cost of £9,000.  Thus profit before rental interest is £15,000 and after interest it is £6,000.

Note the proposed buy to let restriction relates to “finance costs” not just interest – so lender application fees would appear to be covered by the proposals too. 

Example 1

Mr A earns a salary (or if self-employed has a taxable profit) of £25,000.   His “before” and “after” situation is as follows.

  % Tax Current Rules

Budget Proposals

    £ Tax £ Tax
Salary   £25,000   £25,000  
Taxable rental profit   £6,000   £15,000  
Taxable income / profit   £31,000   £40,000  
    Tax band Tax band
Tax at 0% £12,000 £0 £12,000 £0
  20% £19,000 £3,800 £28,000 £5,600
Less tax relief on interest 20%     £9,000 -£1,800
Total tax     £3,800   £3,800

In other words no change in the overall tax liability for this basic rate taxpayer.  If Mr A was an employee suffering PAYE on his salary he will have already paid £2,600 of PAYE leaving him £1,200 of tax to pay on his rental income – i.e. 20% of his taxable rental profit of £6,000.

Example 2

Miss B earns a salary of £75,000.  Her position is altered as follows:

  % Tax Current Rules

Budget Proposals

    £ Tax £ Tax
Salary   £75,000   £75,000  
Taxable rental profit   £6,000   £15,000  
Taxable income / profit   £81,000   £90,000  
    Tax band Tax band
Tax at 0% £12,000 £0 £12,000 £0
  20% £38,000 £7,600 £38,000 £7,600
  40% £31,000 £12,400 £40,000 £16,000
Less tax relief on interest 20%     £9,000 -£1,800
Total tax     £20,000   £21,800

 In this case her total tax bill has gone up by £1,800 due to the restriction on interest relief to 20% on £9,000 of interest expense – so £9,000 x (40% - 20%).  She will have already paid £17,600 of PAYE and so the tax on her net rental income of £6,000 has effectively risen from £2,400 (£20,000 - £17,600) to £4,200 (£21,800 - £17,600) – an effective tax rate of 70% on her net profit.

Example 3

Mrs C might hope that she is not affected by the change since her salary is £43,000 – which together with her rental profit of £6,000 leaves her below the higher rate threshold of £50,000.  But as the following example shows she does get caught by the restriction.

  % Tax Current Rules

Budget Proposals

    £ Tax £ Tax
Salary   £43,000   £43,000  
Taxable rental profit   £6,000   £15,000  
Taxable income / profit   £49,000   £58,000  
    Tax band Tax band
Tax at 0% £12,000 £0 £12,000 £0
  20% £37,000 £7,400 £38,000 £7,600
  40% £0 £0 £8,000 £3,200
Less tax relief on interest 20%     £9,000 -£1,800
Total tax     £7,400   £9,000

 Mrs C will suffer an additional £1,600 of tax as her gross income including her rental profit before tax deduction will be £58,000 – so her additional tax is £8,000 x (40% - 20%).

What should BTL investors do about this?

If an investor is considering buying a new rental property with a buy to let mortgage then they should consider making the investment through a limited company as there is currently no proposal for restricting the deduction of financing costs within companies. Indeed I struggle to think how this could be done without fundamentally changing corporate tax law.  It is worth pointing out that the HMRC proposal is headed “Restricting finance cost relief for individual landlords” (my emphasis) – so it would appear that HMRC is well aware that corporate buy to let investment is not affected.  Whilst there are some costs associated with running a limited company these are small compared with the potential savings.

Landlords with an existing portfolio and who are likely to have additional tax to pay under the proposals have just under two years to consider how best to counter this measure – whether to:

  • Sell up, or
  • Transfer the property into a limited company (which would involve paying Stamp Duty Land Tax and potentially Capital Gains Tax on the sale – as well as arranging a new mortgage), or
  • Do nothing and pay any additional tax.

We will be issuing further guidance in this area once the dust has settled but please note that

  • Whilst the measure is only fully effective in 2020/21, it starts in 2017/18 with one quarter of the interest being restricted to basic rate tax, rising to one half in 2018/19 and three quarters in 2019/20; and
  • There are provisions in the proposals to ensure that the new rules are not more generous than the existing deduction – for instance in years when letting shows a loss.

But as ever we advise all clients to take their own tax advice as we are not tax experts and do not know the detail of clients’ tax affairs.

If you would like one of our consultant mortgage brokers to review the buy to let mortgages you currently have to see where savings could be made, please download, complete and return our Property Portfolio Review form. This service is free of charge and without obligation.

To discuss further please call us on 0845 345 6788.


You might also like to read:

Summer Budget 2015 and the implications for landlords

Summer Budget - Should buy to let mortgage holders panic? 

Buy to Let mortgages for Limited Companies