Sarah Bradford reminds us that residential landlords’ tax relief for interest and finance costs is further reduced in 2019/20.
The system for giving relief for mortgage interest and other finance costs incurred by residential landlords is gradually shifting from one where relief is given as a deduction in computing the taxable profits of the property rental business to one where the relief is given as a basic rate reduction.
This change of approach is something that will be felt by affected landlords, particularly those paying tax at the higher and additional rates.
Relief is generally allowed for interest on loans up to the value of the property when first let. The loans do not need to be secured on the let property to be eligible for relief.
Where are we now?
Prior to 2017/18, landlords were able to deduct interest and other financing costs from rental income in computing the taxable profits of their property rental business.
However, from 2017/18 onwards this started to change, as the relief mechanism entered a transitory phase. Over the transition period, the percentage of interest relieved by deduction decreased, while the percentage relieved by means of a basic rate tax reduction increased.
Relief during the transition period relief for allowable interest is given as follows:
- in 2017/18, relief for 75% of the interest costs is given as a deduction, with relief for the remaining 25% given as a basic rate tax reduction;
- in 2018/19, relief for 50% of the interest costs is given as a deduction, with relief for the remaining 50% given as a basic rate tax deduction;
- in 2019/20, relief for 25% of the interest costs is given as a deduction, with relief for the remaining 75% given as a basic rate tax reduction; and
- in 2020/21 and later tax years, relief for 100% of interest costs is given as a basic rate tax reduction. No interest costs will be deductible.
The tax year 2019/20 is the last tax year for which relief for any interest and financing costs can be given as a deduction. For 2019/20, only 25% of interest costs are deductible (down from 50% in 2018/19). From 2020/21, relief will only be given as a basic rate reduction.
Methods of relief
Relief by deduction is simple – the interest and other financing costs are simply deducted as for other expenses when calculating the profits of the property rental business.
The concept of relief as a basic rate tax reduction is slightly more complicated. Instead of deducting the interest when calculating the profit, the interest (or, in the transitional years, the proportion not eligible for relief by deduction) is ignored when working out the tax on the rental profits. The tax bill is then reduced by the basic rate tax reduction, which in most cases is 20% (being the basic rate of tax) of the interest costs not deducted.
For example, if the interest costs to be relieved in the form of a basic rate tax reduction are £10,000, the tax bill (calculated without taking account of that interest) is reduced by £2,000 (being 20% of £10,000).
If the profit is less than the interest costs or the profit is sheltered by the personal allowance, the basic rate reduction is capped at 20% of the lower of:
- finance costs not deducted in the tax year;
- profits of the business for the tax year;
- total income that exceeds the personal allowance for the year.
This prevents the tax reduction generating a tax repayment – at best, it can reduce the tax bill to nil if the taxpayer is a basic rate taxpayer. Any unrelieved interest costs can be carried forward to the following year.
Example 1: Interest relief restriction in 2019/20
Hetty has rental income of £16,000 in 2019/20. She has no other income. She pays interest of £6,000 on a mortgage on her buy-to-let property. The interest qualifies for relief. She incurs other allowable expenses of £1,400.
2019/20 is the final transitional year. Relief for 25% of the interest, in this case, £1,500 (i.e. £6,000 @ 25%), is given as a deduction.
Hetty’s rental profits after deducting the expenses of £1,400 and deductible interest of £1,500 are £13,100 (i.e. £16,000 - £1,400 - £1,500).
Hetty’s personal allowance for 2019/20 is £12,500. Consequently, she has taxable income for 2019/20 of £600 (i.e. £13,100 - £12,500), on which tax of £120 (i.e. £600 @ 20%) before allowing for the basic rate tax reduction would be due.
Hetty has interest of £4,500 (i.e. £6,000 @ 75%) eligible for relief as a basic rate tax reduction. This is equivalent to a tax reduction of £900 (i.e. £4,500 @ 20%). However, Hetty’s tax bill for the year is only £120, and as such the tax reduction is capped at £120. This is equivalent to a basic rate tax reduction on interest costs of £600, leaving interest of £3,900 unrelieved to be carried forward to 2020/21.
Increased tax bills
Moving from a 50% deduction rate in 2018/19 to a 25% deduction rate in 2019/20 will lead to higher tax bills where the landlord pays tax at the higher or additional rates, assuming rental income and other expenses remain the same.
Example 2: Interest relief restriction - 2018/19 and 2019/20 compared
Mavis is a higher rate taxpayer. She has a salary of £60,000 in 2019/20 from her job in advertising. She also has two rental properties which she lets out, receiving rental income of £20,000. She pays mortgage interest of £8,000 and incurs other allowable expenses of £2,000.
The tax position in respect of the rental income for 2018/19 and 2019/20 is as shown below:
2018/19 2019/20
£ £ £ £
Rental income 20,000 20,000
Expenses (2,000) (2,000)
Interest deduction (4,000) (50%) (2,000) (25%)
(6,000) (4,000)
Taxable rental profit 14,000 16,000
Basic rate tax (£4,000 @ 20%) 800 £6,000 @20% (1,200)
Reduction
Tax payable on rental £4,800 £5,200
Income
The profits retained by Mavis for each year are as follows:
2018/19 2019/20
£ £
Rental income 20,000 20,000
Interest costs ( 8,000) (8,000)
Other expenses ( 2,000) (2,000)
Tax ( 4,800) (5,200)
Retained £5,200 £4,800
Cash basis complication
The cash basis is the default basis of accounts preparation for landlords meeting the cash basis eligibility tests, unless the landlord elects to prepare their accounts using the accruals basis.
While the £500 cap on interest relief applying to traders using the cash basis does not apply for landlords, a different restriction is relevant where the value of the outstanding loans (L) at the end of the tax year exceed the market value of the properties when first let plus any capital improvements (V). The allowable interest is reduced by the fraction V/L.
Example 3: Further restriction
Freddy has three buy-to-let properties in Suffolk, which he rents out throughout 2018/19.
On 5 April 2019, the properties are worth £900,000. However, at the time they were first let, the combined value of the properties was £600,000. Freddy has outstanding loans of £800,000 on 5 April 2019 in respect of which he paid interest of £48,000.
As L (£800,000) is more than V (£600,000), the restriction applies and the interest eligible for relief is reduced to £36,000 (i.e. £600,000/£800,000 x £48,000).
For 2018/19, 50% of the allowable interest (i.e. £18,000) is relieved by deduction and the remaining 50% (£18,000) as a basic rate tax reduction. Assuming the position remains the same for 2019/20, 25% of the allowable interest (£9,000) will be relieved by deduction, with a basic rate tax reduction given in respect of the remaining £27,000.
Practical Tip:
Landlords should assess the impact of the further reduction in the amount of interest relievable by deduction on their tax bill for 2019/20 and ensure that they plan ahead and put aside sufficient funds available to meet the higher bill.
