Residential Landlord Interest Restrictions: Timing Expenses

This article will look at some of the implications of the increasing disallowance of mortgage interest for landlords of residential properties and how actively managing the timing of your expenses may help to lessen the impact in the early years.

Background

Readers will by now (hopefully!) be quite familiar with the impending regime that will progressively disallow the finance costs – primarily mortgage interest – of residential property landlords. The rules apply only to those landlords that are subject to income tax, so individuals, joint investors, partnerships, trusts and estates:

2017/18 75% interest allowable as before, and 25% gets only 20% tax relief as a credit;

2018/19 50% interest allowable as before, and 50% gets only 20% tax relief as a credit;

2019/20 25% interest allowable as before, and 75% gets only 20% tax relief as a credit; and

2020/21 No finance costs allowed against rental profits, and 100% gets a maximum 20% tax relief.

The greater the finance cost in the business, the worse will be the artificial disallowance purely for tax purposes.

	2016/17	2017/18	2018/19	2019/20	2020/21
	£	£	£	£	£
Other Income	15,000	15,000	15,000	15,000	15,000
Rental Profits BEFORE tax adjustments	24,000	24,000	24,000	24,000	24,000
Total Income	39,000	39,000	39,000	39,000	39,000
Add Back – Residential Letting Finance Costs	-	30,000	60,000	90,000	120,000
Personal Allowance	( 11,000)	( 11,500)	( 11,500)		-
	28,000	57,500	87,500	129,000	159,000
Total Income Tax	5,600	16,300	28,300	44,900	57,350
Rent Finance Tax Credit (20%)	-	( 6,000)	( 12,000)	( 18,000)	( 24,000)
SA Tax Bill	5,600	10,300	16,300	26,900	33,350

Benefit/(Cost) on Base Year:		( 4,700)	(10,700)	( 21,300)	( 27,750)

Note: the most recent figures for tax allowances and bands are used, where known.

Analysing the figures

In 2016/17, the base tax year for comparison purposes, Josef is just a basic rate taxpayer, because his taxable profits do not exceed the higher rate tax threshold of £43,000 (including tax-free personal allowance). But when the new regime kicks in, in 2017/18, Josef’s income is swept into the 40% higher rate tax bracket by £24,000, as his income for tax purposes is deemed to more than double (the higher rate threshold in 2017/18 will be £45,000).

Josef does get a 20% tax credit on the £30,000 disallowed interest, reducing his final tax bill by £6,000. But he is paying tax on most of that disallowed interest at 40%, so the tax credit is offsetting only a little more than half of the extra tax he is being charged.

The pain does not end there. In 2018/19, Josef’s ‘tax-adjusted‘ income will be just under £100,000, and his tax bill will increase by exactly £6,000, being the increase in added-back interest in the year (from £30,000 to £60,000) at (40% - 20% tax credit).

But Josef’s tax bill really rockets in 2019/20. His ‘tax-adjusted‘ income has now risen to almost £130,000 and, as a result, he loses all of his tax-free personal allowance (it starts to be eroded when adjusted incomes exceed £100,000). Not only is the additional £30,000 of rental income costing him an extra £6,000 as per the preceding year, but he is losing his personal allowance of (estimated) £11,500 @ 40% - an extra £4,600.

By 2020/21, when the regime is fully installed, Josef’s ‘tax-adjusted‘ income will have risen to £159,000, so he will be an additional rate (45%) taxpayer. In fact, his tax bill will be a little over £33,000. Josef’s non-rental income is just £15,000 and that on its own would result in a tax bill of less than £1,000.

So £24,000 of net rental income will end up costing Josef over £30,000 in tax!

Example 2: Allocating expenses

Admittedly, ‘Josef‘ is a quite unusual case, because the level of interest expense is very high. The figures were chosen because the adjustments move Josef into the 40% tax bracket, past losing his personal allowance, and into the additional rate tax bracket. Many landlords will find themselves facing at least one of those problems, however, depending on the size of their portfolio.

Let’s suppose now that Josef’s properties need some serious repair work: one needs a new roof and another needs a new kitchen. Let’s say that these expenses will cost £20,000 in total. When should Josef choose to incur the repair costs?

The following calculations deduct the £20,000 from each year, so that the outcome can be compared directly with the corresponding year in the original example:

	2016/17	2017/18	2018/19	2019/20	2020/21
	£	£	£	£	£
Other Income	15,000	15,000	15,000	15,000	15,000
Rental Profits BEFORE tax adjustments	24,000	24,000	24,000	24,000	24,000
Deduct One-off Expense in *one* of the years:	(20,000)	(20,000)	(20,000)	(20,000)	(20,000)
Total Income	19,000	19,000	19,000	19,000	19,000
Add Back – Residential Letting Finance Costs	-	30,000	60,000	90,000	120,000
Personal Allowance	( 11,000)	( 11,500)	( 11,500)	( 7,000)	-
	8,000	37,500	67,500	102,000	139,000
Total Income Tax	1,600	8,300	20,300	34,100	48,900
Rent Finance Tax Credit (20%)	-	( 6,000)	( 12,000)	( 18,000)	( 24,000)
SA Tax Bill	1,600	2,300	8,300	16,100	24,900

Benefit/(Cost) on Base Year in this example:		( 700)	(6,700)	(14,500)	( 23,300)

Original Example without £20,000 cost		( 4,700)	( 10,700)	( 21,300)	( 27,750)

Net savings		4,000	4,000