27 June 2023
Since 6 April 2017, tax relief on finance costs have been restricted for most unincorporated landlords of residential property. The restriction means that most landlords can, at best, only claim basic rate income tax relief – equal to 20% of their finance costs – rather than a full deduction from taxable profits which may initially be taxable at the higher rate or additional rates of tax.
The result of the restriction is that taxpayers may suffer an effective 20% or 25% tax charge on notional profits, even if their business made a loss after finance costs. Scottish taxpayers may pay an even higher charge due to the higher tax rates in Scotland.
In addition to the immediate income tax charged on rental income, landlords may also suffer other punitive tax charges that are assessed based on their headline level of taxable income, before the deduction of finance costs, such as the tapering of the personal allowance and the high-income child benefit charge. The result being that landlords may incur additional tax costs which are not proportionate to their cash profits (or losses).
Let’s consider Dave, who has a £2.5m residential property portfolio, funded by about 60% debt. His portfolio generates a rental profit, before finance costs, of £125,000. Following recent rate rises, Dave’s annual interest costs, have increased to around 6% or £87,500 per annum. Dave resides in England and has no other sources of income.
Dave’s cash profit, before tax, is £37,500. However, his income tax liability on this profit is £24,932, equivalent to almost two-thirds of his cash profits, leaving him with profits after tax of £12,568.
As a comparison, if Dave was allowed full tax relief for his mortgage interest, as would have been the case less than a decade ago, his tax liability would be almost £20,000 less.
More problems on the horizon?
Further increases to interest rates will be problematic and could put someone like Dave into a position where they end up paying a significant amount of tax on what is a cash loss.
However, forgetting interest rates for a minute, another problem could be on the horizon for landlords. Earlier this month, it was reported that Rishi Sunak wants a 2p tax cut before the general election. Presuming that this cut would be an isolated cut to the basic rate of income tax, something that Sunak previously expressed his desire to do when chancellor, this could hurt the pockets of residential landlords even more.
As noted above, under the current rules, tax relief on finance costs is restricted to the basic rate of tax. If the basic rate of tax was reduced to say 18%, the tax reducer available to landlords would be reduced by a further 2%, potentially increasing their tax bills once more. In the example of Dave, above, this would result in a further increase to his tax bill of almost £1,000.
Before announcing a tax cut, we would expect the prime minister and chancellor will make appropriate adjustments for any unfortunate knock-on effects, such as that listed above. However, with no indication of immediate support being on the way for landlords, those concerned with rising borrowing costs should seek appropriate tax advice as soon as possible. Such advice should give them peace of mind, in knowing that their rental business is as tax efficient as possible and will allow them to appropriately consider the viability of their business in these trying times.