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The landlord tax, or Sec 24 of the Finance (No.2) Act 2015, has started eating into the profits of landlords, who recently faced a slash in tax reliefs. The mortgage interest relief for landlords which fetched better profits from letting out properties, is no longer the same and is changing dramatically over the period of four years. This has been rolled out in a phased manner beginning April-17, gradually transitioning to a new system where existing relief will get replaced by a basic tax reduction. In other words, higher rate and additional rate tax payer landlords will get lesser profits out of their properties, without any corresponding increase in income. This may appear befuddling to a landlord, as most landlords are not aware of how the changes will impact their earnings. Let’s take a look at comparative scenarios to understand how the changes will affect the profits of a landlord.

Property Tax changes for landlords

Assuming the landlord has £50,000 annual income from employment which puts him in a higher rate tax bracket (40%) for all three years and the only other source of income is property portfolio, where he has a mortgage interest cost of £10,000 per year:

System in 2016/17 System in 2017/18 System in 2018/19
Income from rent (A) £45,000 Income from rent (A) £45,000 Income from rent £45,000
Interest Expense (B) £10,000 Interest towards mortgage (Only 75% of cost is allowed) (B) £7,500 Interest towards mortgage (Only 50% of cost is allowed) £5,000
Expenses (C) £2,000 Expenses (C) £2,000 Expenses (C) £2,000
Income that attracts tax after deducting permitted costs (A-B-C) £33,000 Income that attracts tax after deducting permitted costs (A-B-C) £35,500 Income that attracts tax after deducting permitted costs (A-B-C) £38,000
Tax – calculated @ 40% on taxable income £13,200 Tax – calculated @ 40% on taxable income £14,200 Tax – calculated @ 40% on taxable income £15,200
Profit Before Basic Rate Deduction on Disallowed Mortgage Interest Expense £19,800 Profit Before Basic Rate Deduction on Disallowed Mortgage Interest Expense (E) £21,300 Profit Before Basic Rate Deduction on Disallowed Mortgage Interest Expense (E) £22,800
Disallowed Interest Expense None Disallowed Interest Expense (F) £2500 Disallowed Interest Expense (F) £5000
    Basic rate tax deduction on disallowed interest expense (£2500*20%) (G) £500 Basic rate tax deduction on disallowed interest expense (£5000*20%) (G) £1000
Net Profit £19800 Net Profit(E-F+G) £19,300 Net Profit (E-F+G) £18,800

The table shows that this change in policy which is in its second year since becoming effective, means that the mortgage interest relief is gradually scaled down, every year. Effectively, the table demonstrates that landlords, for the given example will see a £500 cut in profits progressively every year. This cut will scale up gradually till 2020/21, when the flat basic rate tax deduction regime will become the relief standard and rate for landlords, replacing the mortgage interest relief for landlords. In a nutshell, landlords who fall into the higher tax rates or additional tax rates will see lesser and lesser profits every year till 2020/21, and the profit figures of 2021, will more or less be the future profits, unless the policy changes.This grim situation can be sidestepped by one of a few legally permitted arrangements including:

  • The establishment of a limited company into which the rental property can be transferred. By invoking this option, the company will pay tax at the rate of 19%, thereby softening the hit from Section 24.
  • If you have a spouse with income below basic rate threshold, making a declaration of change in beneficial interest vide HMRC Form 17, by changing the ratio of split from 50 : 50 to an actual ownership ratio. However, this involves calculating the ratio in a manner that takes into account the tax rate of each partner in the ownership to ensure that the choice keeps combined tax exposure lower.

In both of the arrangements that are legally permitted to overcome the provisions of Sec 24, without violating the GAAR (General Anti Abuse Rules), considerable professional expertise is required to assess the suitability, and assist in compliance. There are multiple reporting requirements, which may be difficult for a landlord to accomplish, given the technical nature of the requirements. Setting up a limited company requires an accurate compilation of annual accounts that needs to be submitted to Companies House. Additionally taxes that apply, need to be computed and remitted within the deadlines. This requires the professional assistance of accountants. Similarly in the second option where a change in the ratio of split needs to be communicated to the HMRC, it needs to be preceded by a thorough calculation to ascertain the ideal split ration to keep combined tax exposure less. Here again, a qualified and experience accountant will be better equipped to handle the calculations and the various exemptions and reliefs to arrive at the best split ratio which can be conveyed to the HMRC.

Phased changes restricting finance cost reliefs for landlords

Restriction on finance cost reliefs for landlords

These changes that restrict relief for finance costs on residential properties have begun rolling out in a phased manner. This will eventually lead to the migration to a basic rate reduction for landlords in place of the existing mortgage interest relief for landlords. Finance costs include the interest on a mortgage, or loans availed for the purpose of furnishing a rental property. It also includes the consultancy fees that were disbursed for the purpose of facilitating the loan or mortgage. However, from 2020/21, landlords will receive a basic rate reduction from their income tax, in place of the existing deductions of finance costs, which had been used as a method for calculating property profits and tax exposure. To soften the process, the Government has rolled out the changes in a phased manner as follows :

  • In the preceding year 2017 to 2018, permitted deductions from property income were 75% of finance costs, with a basic rate tax deduction of 25%.
  • In the current year, i.e. 2018 to 2019, the permitted deductions from property income will be 50% of finance costs, while the corresponding basic rate tax deduction will stand at 50%.
  • In the following year - 2019 to 2020, the permitted deductions from property income will be 25% of finance costs, while the corresponding basic rate tax deduction will swell to 75%.
  • From 2020 to 2021, and onwards, permitted deductions from property income will be dispensed with, and replaced by a basic rate tax reduction of 20%.

The reason for a large number of landlords remaining unaware of the changes that will eat into their profits is the fact the first year change is the least among the four years, which would have hardly reflected on the actual tax exposure. However, in the present year and the following years, this is set change, as the transition moves into the more serious and bigger changes in terms of tax exposure and cut in reliefs. It is time landlords looked at the most suitable and legally permissible options to sidestep the Tenant Tax and continue to enjoy similar profits as earlier. With the assistance of qualified accountants, possessing extensive experience in Property Tax and the various applicable and permissible exemptions, landlords can pre-empt a cut in profits.

Call us on 03300 88 66 86 to book your free property consultation meeting, if you are concerned or have been affected by the new changes.

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