Loans To Purchase Property – How To Achieve The Best Tax Relief

Julie Butler outlines the importance of careful tax planning around property ownership, to ensure that tax efficient loans are used to achieve the maximum tax reliefs and associated loans are tax-efficient.

In the ‘dim and distant past’, homeowners could achieve income tax relief on the interest paid on a loan to buy their own home. This relief took various forms including a ‘MIRAS’ (mortgage interest relief at source) system. When this tax relief was restricted and then subsequently withdrawn, there followed a general view by taxpayers that no income tax relief was allowed on the purchase of property that they owned. There are, however, ways around this tax problem. Interest paid on loans to purchase rental (‘buy to let’) property is tax allowable. Therefore a clear tax planning strategy is to repay ‘home loans’ and increase loans to purchase rental property.

An obvious point is if, say, a taxpayer has four rental properties together with a main residence, it makes ’tax sense’ to repay the home loan from the sale of, for example, one of the four properties. Considerations as to property investment planning, achieving the best rates of interest, capital gains tax and stamp duty land tax mitigation would also have to be considered. A total historic review is recommended, and to keep reviewing the position on an ongoing basis, as should always be the case where borrowing and property are concerned, particularly when investment property is part of the equation.

Income tax relief can be obtained on the interest paid on loans, when purchasing property used in a business or on business property. Confusion does, however, arise on the purchase of a farm or smallholding that combines both a main residence and business property. Basic tax planning is to ensure that borrowing is obtained against the business property in preference to the farmhouse for income tax purposes. Although where some of the farmhouse is used in the business, income tax relief can be achieved in respect of the loan interest paid. As with all tax planning, income tax relief has to be considered ‘in the round’, with financial planning (e.g. optimum rates of interest), long-term matters such as inheritance tax (IHT), and succession planning.

In calculating IHT liabilities, relief for loans and debts have been available in a very favourable order of set-off for businesses. In principle, it was possible to secure maximum IHT relief by securing business loans against non-business assets, i.e. against private assets. It was then possible to obtain business property relief (BPR), agricultural property relief (APR) or woodland deferral relief on the whole of the business assets, and the private assets were reduced by the loans, thus producing IHT savings. For IHT purposes, it is necessary to determine which asset has its value reduced by a loan debt. It is generally the asset against which the debt has been charged or secured, which might not have been the asset the loan was used to obtain in the first instance. Finance Act 2013 introduced a radical change to this advantageous treatment.

An example of such a structure would be where a family business took out a loan to help the trading operation, with the loan being secured against the family home. Full BPR and APR was therefore claimed against the business/agricultural assets. IHT that is payable on the family home on death was reduced. Many employees set a target of being ‘debt free’ when they retire and, above all, being free of debt when they die, but in business that luxury is not often available. Loans are frequently needed to keep the business going and sometimes to survive, with this being particularly relevant during the recent recession.

The type of planning brought about to avoid IHT through offset against private assets has been well-used and it is now regarded as ‘abusive’ by HMRC. There had been no advance warning of the Finance Act 2013 restrictions. Farming organisations approached MPs seeking their support for genuine commercial arrangements. The result has been to make the change from 6 April 2013. 

In addition to income tax losses, on which a taxpayer may wish to obtain tax relief, there are capital losses, for example loans to traders and for the purchase of shares. Where an individual lends money to a trade that subsequently becomes irrecoverable, partially or in full, relief may be found in the tax legislation (at TCGA 1992, s 253). ‘Trade’ is defined to include a profession or vocation, but explicitly excludes “a trade which consists of or includes the lending of money” (s 253(1)(a)).

Loans are not defined in the legislation, and may be in the form of cash, bank overdrafts, a bank loan (to repay a loan taken out to lend to a trader) or simply a credit balance in a director’s loan account.

A basic loan that taxpayers want to claim tax relief on is the irrecoverable director’s loan account (DLA). HMRC is not prepared to allow tax relief unconditionally. 

There are currently adverse tax rules relating to expensive UK sited property held in a limited company. These are contained within the annual tax on enveloped dwellings (ATED) legislation. This affects property valued at in excess of £2 million as at 1 April 2012, or at acquisition, if later. Budget 2014 subsequently announced a reduction in the threshold from £2 million to £500,000 to be introduced over two years, and from 1 April 2015 a new band will come into effect for properties with a value greater than £1 million, but not more than £2 million.    

There has been, and continues to be, much planning to try to remove such properties from the limited company by the directors/shareholders if the property cannot qualify as exempt from ATED. There are a range of valuable exemptions available; these include properties open to the public for at least 28 days a year and run as a business, most dwellings owned by charities, and farmhouses occupied by a working farmer to name but a few. When the property that is owned by the company has been purchased by a company loan or DLA this needs to be incorporated into the overall ATED planning.

Tax planning around property ownership must always incorporate careful planning to ensure that tax-efficient loans are used to purchase the property. This will involve maximising tax relief on loan interest for income tax, on IHT relief where the loan is secured post Finance Act 2013, and CGT relief on the disposals that follow.  Obviously, such planning needs to be considered before arrangements are made and the loan is put in place, but now the full impact of Finance Act 2013 and ATED is understood, there is scope for historic/retrospective loan planning reviews to be undertaken. Act now and review the position, it would be far more damaging if a problem were to surface as a result of an HMRC review or probate examination, etc.