How Flexible Is Tax Relief On Finance Costs?

Lee Sharpe looks at the opportunities for tax relief on loan interest for property investors.

The rules for tax relief on loan interest are (arguably) much more flexible than they used to be – thanks in no small part to HMRC’s generosity. So, just how helpful are the rules?

The rules for finance costs are fundamentally different between individuals and companies, although they frequently have the same result. 

Companies have the ‘loan relationship’ regime, which takes a permissive approach to gains and losses and, broadly, evaluates the overall movement for accounts purposes without getting too hung up on whether or not something qualifies as ‘interest’.  This recognises the mutability of corporate finance arrangements – although there are some hard lines around loans between connected parties, and in relation to shares, etc. In the round, there is little distinction for companies between ‘normal’ interest charged and a capital loss on a loan: generally, both would be deductible.

Individuals used to claim tax relief for interest against total taxable income, rather than as a deduction against rental income. The method was quite formulaic. But this changed and individuals are now on a similar footing to that for companies, inasmuch as it is now claimed directly in the rental income and expenditure account. Nevertheless, there remains a quite distinct line between interest, which is deductible from income, and any capital movement in the underlying loan itself, which would retain its capital ‘flavour’.

Despite these distinctions, there is much in common between the two regimes. For instance, both of them effectively start with the figure in the accounts, and then adjust if necessary. 

Rental properties are normally considered an investment activity, either in a company or when held personally. Property development – building or renovating properties for re-sale – is a trading activity. From a loan interest perspective, it makes little difference to the calculation or deductibility, broadly, so long as the activity is undertaken on a commercial basis. 

HMRC confirms that it makes no difference how the loan is secured. As it says in its Business Income Manual (at BIM45685):

“The security for the borrowed funds does not determine the use of those funds. It is very common in small businesses for loans to be secured on the proprietor’s home, because that is the only substantial owned asset. This is not relevant to the consideration of the use of the funds borrowed.” 

Where the loan is applied in part for business purposes and partly for private purposes, then the interest cost can be apportioned (as per BIM45670). This remains the case for simple overdrafts and offset accounts, to the extent that the borrowings finance a business purpose. If the proportion of business to private borrowings changes at some point, then the amount claimed should also change accordingly (BIM45695).

HMRC confirms (at BIM45675) that the interest on a pre-existing private loan may be claimed if the funds are subsequently applied for a business purpose. This is particularly helpful for property investors who decide to add a former residence to their property business. 

Keith and Felicity live in a substantial property, which has grown significantly in value since they bought it. They are confident that this will continue, but they no longer need such a large house now that their children have grown up and moved out. They decide to let the property out, but to keep hold of it for the long term. 

Their original lender agrees to continue with the original mortgage on favourable terms because of their substantial equity and a further mortgage is taken out to fund a much more modest property as their new residence. 

The interest on the original mortgage will now be a deductible expense against any rental income on the first property, even though the loan was for a private purpose when originally taken out. But what about the new mortgage? 

While a loan to fund a private purpose is not normally deductible, HMRC guidance does allow relief on finance to fund the withdrawal of capital from a business, no matter what the capital is then applied for. 

For example, a person might introduce personal capital of £25,000 as a 10% cash deposit to secure a property at auction, giving him a few days to sort out the finance. If the cash funds are subsequently replaced with loan finance, the interest is still deductible – provided the withdrawal does not leave the taxpayer effectively owing money to the business.

Many readers will be familiar with the following example from BIM45700.

Mr A owns a flat, which he bought ten years ago for £125,000. He has a mortgage of £80,000 on the property. He has been offered a job in Holland and is going to move there. He intends to come back to the UK at some time. He decides to keep his flat and rent it out while he is away. His London flat now has a market value of £375,000.

The opening balance sheet of his rental business shows:

Mortgage £80,000 Property at market value £375,000 

Capital account £295,000

He renegotiates his mortgage on the flat to convert it to a buy to let mortgage and borrows a further £125,000. He withdraws the £125,000, which he uses to buy a flat in Rotterdam.

The balance sheet at the end of Year 1 shows:

Mortgage     £205,000 Property at market value £375,000 

Capital account B/F £295,000

Less Drawings £125,000

C/F   £170,000

Although he has withdrawn capital from the business, the interest on the mortgage loan is allowable in full because it is funding the transfer of the property to the business at its open market value at the time the business started. The capital account is not overdrawn.”

In essence, even though the second loan actually funded a private residence, the aggregate loan finance was still less than the value of the asset Mr A introduced to the business, so the business is not ‘out of pocket’ and interest should be allowed in full. 

What if the mortgage were secured on the new private property?

Some advisers baulk at the alternative scenario that part of the finance is secured against the new Rotterdam flat: how can a separate private mortgage be deductible? I should argue that we have already established that the source of the collateral is irrelevant, thanks to BIM45685. If, as a result of the finance, Mr A is able to introduce a higher-value asset to his property business, then I believe that the interest should be allowed in full. 

Note that the example suggests that the London flat is ‘introduced to the property business’ at its full value, and only then are funds withdrawn to fund the Rotterdam flat. This seems unlikely: Mr A has to vacate his London property first before it can be let and he would presumably have bought the new Rotterdam flat already, so he had somewhere to go. 

HMRC’s position on loan finance is refreshingly flexible. Although a pre-existing loan for a private property may not be deductible where it has no link to the business, if it can be shown that the overall arrangements have been brought about to fund the introduction of a business asset which is more valuable than the aggregate debt, then I believe a full interest claim should be allowed – even if it includes a separate mortgage on a private property. However, guidance should be sought in order to ensure the claim is made to best advantage.