An estimated 1 in 30 adults in the UK are landlords. But new rules on tax relief mean that net income from private rental properties could be reduced by tens of thousands of pounds per year. The new rules are particularly complex for trustees and executors.
The good news is that there may be steps that can be taken to reduce exposure.
Adrian Moss and James Amico of Penningtons Manches’ private client team explain:
Prior to 6 April 2017, the calculation of rental income was relatively simple, ie the gross rent received during the tax year, less any expenses wholly and exclusively incurred in relation to the letting of a rental property – this could include utility bills, repair costs and often most prominently mortgage interest.
From 6 April 2017, the ’finance expenses’ deductible in calculating the taxable rents received have been restricted. Finance expenses will most commonly relate to the mortgage interest a landlord pays but can also include interest payments on loans which have been obtained to furnish the property, overdraft fees, banking fees, etc.
These restrictions will apply to all landlords of a residential property. These landlords can either be individuals, trustees or executors. The restrictions will not apply to companies, commercial lets or furnished holiday lets.
Prior to 6 April 2017, finance expenses were wholly deductible in calculating the taxable income for the year. It is intended that by the year ended 5 April 2021, no finance expenses will be deductible in calculating the taxable rents. Instead a tax credit at the basic rate will be applied to the resulting income tax payable.
To give landlords time to adjust to these new measures (and also to ensure their rental position is still viable), these restrictions are being introduced over a number of tax years as follows:
|Tax year ended||Proportion of financial expenditure deductible||Proportion of financial expenditure qualifying for a basic rate tax credit (currently 20%)|
|5 April 2017 (or earlier)||100%||0%|
|5 April 2018||75%||25%|
|5 April 2019||50%||50%|
|5 April 2020||25%||75%|
|5 April 2021
The extent of finance expenses (both immediately and in the future) is the main factor in assessing the impact of the changes. Furthermore the impact will largely depend on the taxpayer’s overall levels of income before and after rental property income is considered.
It is important for landlords to assess their hypothetical income tax position to understand the impact and to what extent the mitigation steps described below may be worthwhile.
The taxpayer owns two residential buy-to-let properties which are their main source of income. In addition to this, they earn an annual salary amounting to the personal allowance each year.
Prior to the introduction of these changes the taxpayer is only subject to income tax at the basic rate, making a net tax profit of £24,000. As the restriction of financial expenses takes effect, the taxpayer’s net rental income increases resulting in them being subject to income tax at the higher rates.
By 2020/2021 the taxpayer will be subject to an additional £7,100 of income tax. The introduction of the deductible basic rate tax credit will not fully account for this increase and as a result the taxpayer’s net income for the year will reduce by 13% to £20,900.
|Tax year ended 5 April||2017||2018||2019||2020||2021|
|Net rental income||30,000||35,000||40,000||45,000||50,000|
|Tax credit for finance exp||Nil||(1,000)||(2,000)||(3,000)||(4,000)|
|Total income tax payable||6,000||6,300||7,100||8,100||9,100|
|Net profit after tax||24,000||23,700||22,900||21,900||20,900|
The taxpayer owns a large property portfolio holding 60 properties with circa 50% gearing. Due to the high income levels, the taxpayer’s personal allowance is fully abated.
Similar to the example above, the restriction of financial expenses results in the taxpayer’s taxable income increasing by £125,000. By 2020/21 the resulting increase in income tax reduces the taxpayer’s net income by 11% or £25,750 per year.
|Tax year ended 5 April||2017||2018||2019||2020||2021|
|Net rental income||420,000||446,250||472,500||498,750||525,000|
|Tax credit for finance exp||Nil||(5,250)||(10,500)||(15,750)||(21,000)|
|Total income tax payable||175,100||181,363||187,725||194,288||200,850|
|Net profit after tax||244,900||238,638||232,275||225,713||219,150|
The operation of the restriction for trusts is complex and depends on the terms of the trust. For discretionary trusts, the basic rate tax deduction is allowable in a similar manner to individual owners. However, with life interest or interest in possession type trusts, the basic rate deduction is not allowed and there is a mechanism to pass the possible basic rate deduction to the beneficiary to use in their personal tax return. There can be quite adverse outcomes in applying this mechanism and it is recommended that trustees of life interest trusts with residential property finance costs seek expert advice.
Landlords are considering a number of possible steps to mitigate the tax impact of the changes and many are considering an overall tax and succession plan.
Penningtons Manches’ private wealth tax advisers offer expertise in property tax and succession planning. The firm also benefits from expertise in property transactions and incorporation. Please contact us if you wish to discuss your or your clients’ position.
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