As of April this year, landlords can no longer deduct the entire cost of their mortgage interest from income generated by rental, when working out their profits.
The recent complex change in buy-to-let tax rules means a gradual decrease of mortgage interest tax relief to 20% during a three-year transitional period. In 2020 none of the interest will be tax-deductible, and buy-to-let landlords will have to pay tax on the full amount, less a 20% credit on mortgage interest. The implications mean higher tax bills for many, and a tax on non-existent profits for some. As a buy-to-let investor, this is likely to have a huge effect on your earnings, but it is important to understand the situation before you decide on the best course of action.
Working out the costs
Buy-to-let landlords can now only offset 75% of their mortgage interest against their profits, shrinking to 50% in 2018, 25% in 2019 and finally zero in 2020. According to accountants Smith & Williamson, higher-rate taxpayers whose mortgage costs are above 75% of rental income will find their investment becomes loss making, and for additional-rate taxpayers, the threshold is 68% of rental income.
To give an example:
A landlord with a rental income of £15,000 and mortgage interest of £11,000, would previously have been taxed on the difference (40% of £4,000) paying £1,600 tax. In 2020, paying tax on the profit £6,000 (40% of £15,000) minus 20% tax credit on the interest £2,200 (20% of £11,000) means the landlord will end up with a tax bill of £3,800. This significant increase of £2,200 will put buy-to-let in a position where a small increase in interest rates could wipe out any profit altogether.
Who is affected
Higher-rate taxpayers with a large mortgage on their buy-to-let properties will have to pay substantially more tax, and some basic-rate taxpayers will be affected too as the changes will move them into a higher-rate tax bracket. Some may even see a tax rate of more than 100%, meaning they will have to pay more than all their profit in tax, leading to a loss-making investment. Mortgage-free landlords and limited companies that own properties will remain unaffected by the changes. Setting up a limited company may help to reduce the impact of this new system, but remember that transfer of property ownership is considered a sale, and so may itself be subject to capital gains tax. The choice of mortgage options may also be limited, because of the restrictions and amount of products available.
What are your options?
If the amount of tax you have to pay ends up making your investment financially unviable, then it is important to consider the options available, such as remortgaging, selling, raising the rent, and the aforementioned setting up of a limited company. The benefits of transferring ownership of a property to a partner in a lower tax band needs to be weighed up as it could also incur capital gains tax, and may in turn end up raising the tax bracket for your partner. Looking for ways to increase the rent could include refurbishment, and perhaps even restructuring to maximise on space and therefore possible income. Remortgaging could secure lower mortgage rates or reduce the mortgage amount, while selling would pay off the existing mortgage and limit the tax implications.
The consequences of the staggered changes to tax relief for buy-to-let landlords are substantial, so it is important to consider the options available, and seek professional advice before deciding what is best for you. With only a short amount of time to implement any change to your circumstances, it may be necessary to make a decision sooner rather than later.