Get ready for buy-to-let tax changes

Last week Buy-to-let landlords Steve Bolton and Chris Cooper failed in their legal battle against the planned government tax increase on buy-to-let properties.

Although their campaign to axe the Tenant Tax will continue to lobby the government a successful outcome can’t be guaranteed, and landlords need to be sure they understand what the proposed changes are for next April - just over five months away.

Calculation of profit and tax

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. And 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.

The new rules change the way that profit is calculated for landlords. Finance costs will no longer be taken into account to work out taxable property profits. 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 who pays mortgage interest of £9,000 will in future have to pay tax on the full amount of £10,000, now considered to be ‘the profit’, less a 20% credit on the mortgage interest of £9,000.

It is really an amendment – for landlords – of the generally accepted accounting principles used for businesses. The government is no longer considering ‘borrowing or finance’ as an ‘expense’ and this has an effect on how it determines ‘profit’.

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 large increase of £1,800. A landlord who pays 45% tax could expect a tax bill of £2,700, compared with £450.

(credit: figures, MoneySuperMarket.com)

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 accountant Smith & Williamson. 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.

Passing these extra costs onto tenants in rents is currently a contentious issue but there is evidence to suggest this is what many landlords will do. For example two thirds of 2,883 landlords surveyed by the Residential Landlord’s Association said they would increase their rents to offset the tax changes.

(credit: figures, MoneySuperMarket.com)

So who will be affected?

According to the government only one in five landlords are expected to pay more tax when new section 24 rules, under the Finance Act 2015, are implemented, but a number of industry experts dispute this.

  • These changes will affect you if you let out residential properties as an individual, or in a partnership or trust.
  • UK resident individual that lets residential properties in the UK or overseas
  • Non-UK resident individual that lets residential properties in the UK
  • Individual who lets such properties in partnership
  • Trustee or beneficiary of trusts liable for income tax on property profits

Who won’t be affected?

  • UK resident company
  • Non-UK resident company
  • Landlord of furnished holiday lets

If you operate as any of the above, you will continue to receive relief for interest and other finance costs as usual. Recent research suggests that some landlords are buying as limited companies in order to avoid the tax.

How is it to be phased in?

The changes will be phased in gradually from 6April 2017 and will be fully in place from 6 April 2020.

As of April next year, you will still be able to deduct some of your finance costs when working out your taxable property profits during the transitional period. These deductions will be gradually withdrawn. They will be replaced with a basic rate tax relief reduction.

The percentage of finance costs deductible from rental income will firstly be reduced by 25%, then 50%, then 75%, then 100% at the end of the rollout.

YearPercentage of finance costs

deductible from rental income

Percentage of basic

rate tax reduction

2017-1875%25%
2018-1950%50%
2019-2025%75%
2020-210%100%

*This article is not legal advice and is not intended to be relied on as such. You should always seek professional advice.

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