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Explained: Restrictions to mortgage interest tax relief

In our last two blogs, we took a closer look at incorporation and why this is a rising phenomenon among landlords. In nearly all cases, incorporating – i.e. transferring a property portfolio to a limited company to pay lower taxes on profits – is being done to offset the damage that could be caused by the phasing out of mortgage interest tax relief.

But what’s the phasing out of mortgage interest tax relief all about, when is it happening, and why is the landlord community so fervently against it?

To answer this question, we need to head back to the distant days of the 2015 Budget, when George Osborne was still in charge of the purse strings, David Cameron was Prime Minister and the idea of Britain leaving the EU was as likely as anyone but Celtic winning the SPL.

Letting Solutions February 2017 Blog 1

For it was in this Budget that the plans for the changes to mortgage interest tax relief were first set out, causing uproar among those who operate in the private rented sector. Despite concerted efforts to get the government to change its mind or soften its approach – including lobbying, legal challenges and pressure from industry bodies and protest groups – the changes are going ahead as planned, with Theresa May and Philip Hammond determined to finish what Osborne and Cameron started.

In April this year the changes will start to be phased in, with the new rules fully implemented by April 2020. Up until now, landlords have been able to claim mortgage interest tax relief at their marginal rate of tax. Under the current system, a landlord with a rental income of £10,000 a year, paying mortgage interest costs of £5,000 a year and £1,000 in other costs, would make a profit of £4,000 per annum. This profit is then charged at a landlord’s marginal rate – for basic rate taxpayers this is currently 20%, for higher rate taxpayers 40% and for top rate taxpayers 45%.

At present, a landlord in the basic rate bracket would pay £800 in tax while a higher rate taxpayer would pay £1,600, leaving a final net profit of £3,200 and £2,400 respectively. Under the new rules, however, this will all change, with landlords no longer able to deduct mortgage interest costs from taxable profits. Instead, every landlord will be able to claim at the basic rate of income tax (20%), no matter which tax bracket they sit in.

This will be phased in over four years but many landlords fear their profits are going to be badly hit as a result. It’s not hard to see why. Using the same example as above, but with the new rules applied, the figures start to look markedly different. With mortgage interest tax relief no longer deducted, gross profit per year would be £9,000, with only £1,000 in other costs eating into this.

On this profit, a basic rate taxpayer would be charged £1,800 in tax, while a higher rate taxpayer would be shelling out £3,800. Of course, a deduction of 20% on the £5,000 mortgage costs is still allowed, but at the basic rate this would only equal £1,000. So the amount a basic rate taxpayer would have to pay falls to £800 a year, the same as it currently is now. However, a higher-rate taxpayer – the bracket that a high proportion of landlords fall into – would still have to pay £2,800 in tax, significantly more than the £1,600 they pay under the current rules.

So, to boil it down to its base level, under the new rules basic rate taxpayers pay the same tax, but higher rate taxpayers pay significantly more. What’s more, basic rate taxpayers might be pulled into a higher tax threshold by the new rules, as the amount they make on their property goes up.

Those higher-rate taxpaying landlords who have mortgage interest that is 75% or more of their rental income could see their profits badly affected by the new legislation.

There are, of course, ways to offset or limit the detrimental effects of the phasing out of mortgage interest tax relief. Incorporation, as we mentioned previously, is one, although it does have pros and cons. Transferring ownership of a property to a partner or spouse who is a basic-rate taxpayer is another, as is switching to a shorter-term fixed-rate mortgage deal to secure a lower interest rate.

As we said before, none of this should be done without the advice and assistance of an experienced tax adviser, who will help decide the best approach for you. You should explore all available options and avenues, liaising with experts in the field regarding how the tax changes will affect your own individual circumstances and property portfolio. Each landlord will be in a different situation, so a broad, one-size fits all approach will not be on the cards.

For more information about the changes coming into play in April, please get in touch with Letting Solutions on 01506 496 006. As West Lothian’s first dedicated lettings agency, we also offer free and instant online valuations to give you an idea of how much you could be charging in rent.