Landlords could in future struggle to make a profit following the chancellor’s decision in the 2015 Summer Budget to cut mortgage interest tax relief.
At the moment, landlords can claim tax relief on their mortgage interest payments. In other words, they can offset the cost of the mortgage interest from the rental income when they calculate their profits.
So, if a landlord collects rental income of £10,000 a year, but pays mortgage interest of £9,000, the profit is the difference between the two, or £1,000.
Landlords pay tax on their profits according to their income tax band. So, in this simplified example, a basic-rate taxpayer would pay 20% tax on £1,000, or £200, and keep £800. The tax bill for a 40% taxpayer would be £400, leaving £600, or £450 for a taxpayer at the 45% additional rate, leaving £550.
Reduction in relief
But this situation won’t last for much longer. In his Summer Budget, George Osborne announced that landlords would no longer be able to deduct all their mortgage interest when they work out their profits.
It’s important to remember that HMRC will treat any transfer of ownership of a property as a sale
Instead, mortgage interest tax relief will gradually be cut back to 20% between 2017 and 2020.
So, our landlord with rental income of £10,000 and £9,000 of mortgage interest to pay will in future have to pay tax on the full amount, less a 20% credit on the mortgage interest.
The tax bill for a higher rate taxpayer would therefore work out at £4,000 (40% of £10,000 profit) minus £1,800 (20% of £9,000 interest), which equals £2,200, up from £400 under the current tax regime.
That’s a whopping increase of £1,800. A landlord who pays 45% tax could expect a tax bill of £2,700, compared with £450.
Effect on profits
If you are a higher-rate taxpayer, the new tax will wipe out your returns if your mortgage interest is 75% or more of your rental income.
The threshold for additional-rate taxpayers is when mortgage interest reaches 68% of rental income, according to Smith & Williamson, the accountant.
The tax liability of a basic-rate taxpayer is unchanged. However, the new profit calculation could push a basic-rate taxpayer into a higher tax band.
Impact on limited companies
Limited companies are not affected by the changes to mortgage interest tax relief.
Many landlords are therefore setting up a company to minimise the impact of the new tax regime. However, it’s important to remember that HMRC will treat any transfer of ownership of a property as a sale, so there could be a capital gains tax bill to pay (making expert advice essential for most private landlords).
The mortgage options might also be limited because lenders offer a restricted choice of home loans to companies.
A landlord could also transfer ownership of the property to a spouse or partner who is in a lower tax band. But again, there are CGT implications. You also have to be careful that the property ownership does not lift the spouse into a higher tax bracket.
Other restrictions on reliefs
The tax attack on landlords does not stop at mortgage interest. The chancellor also imposed tighter restrictions on the wear and tear allowance.
From April 2016, landlords will no longer be able automatically to deduct 10% of their rental profits as notional wear and tear. They will be able to claim tax relief only on costs they have actually incurred, such as if they have bought a new sofa or bed for the property.
They will also have to keep receipts. Previously, landlords could write off the 10% even if they had not spent a single penny on repairs or replacements.
It will also be possible to offset ‘allowable expenses’
Allowable expenses are costs incurred in the day-to-day running of the property, such as:
-letting agents’ fees
-legal fees for lets of a year or less, or for renewing a lease for less than 50 years
-buildings and contents insurance
-interest on property loans
-maintenance and repairs to the property (but not improvements)
-utility bills, like gas, water and electricity
-rent, ground rent, service charges
-services you pay for, like cleaning or gardening
-other direct costs of letting the property, such as phone calls, stationery and advertising
Allowable expenses don’t include ‘capital expenditure’ – such as buying a property or renovating it beyond repairs for wear and tear.
And that’s not all. A stamp duty surcharge for landlords was announced in the Autumn Statement. So too was the requirement for landlords to pay capital gains tax (CGT) on any profits within 30 days of selling a property from April 2019.
Since September 2015, landlords in England must also fit smoke and carbon monoxide alarms or face a penalty of up to £5,000.