From 6 April 2017, income tax relief restrictions for loan finance costs apply to residential landlords which, as they are phased in, will put financial pressure on many.
It is very likely some landlords will find themselves paying more in tax than their net rental income.
Action is therefore needed by all individuals, partnerships or trusts that are residential landlords to understand their potential exposure – doing nothing is not a sensible option.
Why is action needed?
The amount of tax relief that such residential landlords can claim on mortgage interest and other qualifying loan finance costs has already been cut. From 6 April 2017, relief at higher income tax rates is partially restricted, with the full restriction due to be in place for 2020/21.
This tax year, 25 per cent of residential landlords’ qualifying loan finance costs will receive tax relief at the basic rate of 20 per cent. In 2018/19, this will rise to 50 per cent and by 2020/21 all such borrowing costs will receive tax relief at the basic rate only. This is achieved by taxing rental income before loan finance costs at the landlord’s marginal tax rate and then deducting basic rate tax relief for the finance costs.
John is a residential landlord and receives rent of £6,000 per year after deducting all related costs other than loan finance costs. His mortgage interest cost is £4,000 per year and he pays income tax at 40 per cent.
Before 6 April 2017
John’s net rental income was £2,000 (£6,000 - £4,000). The tax charge on the £2,000 net income at his marginal tax rate of 40 per cent was £800.
John’s net rental income remains at £2,000. However, higher rate tax relief on the mortgage interest is fully restricted, with only basic rate tax relief given.
Therefore, John’s tax charge is calculated by taxing his rental income before interest costs of £6,000 at his marginal tax rate (ie £6,000 x 40 per cent = £2,400) and then deducting basic rate tax relief for the mortgage interest (ie £4,000 x 20 per cent = £800), giving a net tax cost of £1,600.
John’s effective tax rate on his net rental income in this scenario would be 80 per cent.
If the mortgage interest were £5,000 rather than £4,000 John’s effective rate of tax would be an astonishing 140 per cent.
The only way for residential landlords to understand their potential tax exposure is to crunch the numbers as circumstances will differ for each individual.
Once armed with this information, appropriate actions can be considered. These may include repaying/reducing debt, gifts to family members, incorporation, diversification into commercial property, or even selling property. Tax advice should be sought before any further action is taken, both to confirm the expected tax position of current arrangements and to understand the tax implications of the different options that may be available to mitigate any exposure.