Investors are now getting to grips with the latest change introduced by the Exchequer - mortgage tax relief reductions. Here’s an in-depth look at what has changed this tax year, how investors will be affected and what new strategies are available.
Before April 2017, landlords were able to deduct their mortgage interest costs (and other additional costs such as arrangement fees) from their rental income before calculating their final profit. From the start of this tax year, a new system is being phased in with annual reductions before being fully-implemented at the start of the new tax year in 2020.
Let’s break this down - what does this actually mean?
Previously, if, for example, the rental income from your property was £10,000, your mortgage interest costs were £4,000 and other costs were £2,000, you’d be left with a profit of £4,000.
You would then be taxed on that final profit at either 20% if you’re a basic rate taxpayer or 40% if you’re a higher rate taxpayer; 45% for top rate taxpayers. In this scenario, a basic rate taxpayer would pay £800 and a higher rate taxpayer would pay £1,600.
By 2020, landlords will not be able to deduct their mortgage interest costs at all, but they will, instead, be able to claim a basic rate tax reduction, which will be a flat rate of 20% of the mortgage interest cost. So, using our example, this would calculate the profit to be £8,000 rather than the £4,000, as it was before; a basic rate taxpayer would then have to pay £1,600 and a higher rate taxpayer would pay £3,200. However, this is when the basic rate tax reduction comes in, which takes off 20% (of the mortgage interest costs, not the total). Once this is factored in, the figures then go down from £1,600 and £3,200 to £800 and £2,400 respectively.
Old System
Income (£10,000) - Mortgage Interest Costs (£4,000) - Other Costs (£2,000) = Profit (£4,000)
20% of Profit (£4,000) = Tax Payable (£800)
OR
40% of Profit (£4,000) = Tax Payable (£1,600)
New System
Income (£10,000) - Other Costs (£2,000) = Profit (£8,000) {includes Mortgage Interest Costs of £4,000}
20% of Profit (£8,000) = Tax Payable (£1,600)
Tax Payable (£1,600) - 20% of Mortgage Interest Costs (£800) = Final Tax Payable (£800)
OR
40% of Profit (£8,000) = Tax Payable (£3,200)
Tax Payable (£3,200) - 20% of Mortgage Interest Costs (£800) = Final Tax Payable (£2,400)
What we notice here is that for the basic rate taxpayer, nothing has changed in terms of what’s payable under the new system, only the order and process in which it is calculated and deducted; it is the higher rate taxpayer that will mainly be affected by the changes.
This was introduced by the government as a way to cut ‘generous tax treatment’ to wealthier landlords and creating a blanket of equal opportunity, as was the aim with the introduction of the 3% Stamp Duty levy.
In the meantime, landlords are steadily being weaned off the old system, whereby until 2018 landlords will be able to deduct mortgage interest costs on 75% of their overall finance costs, with 25% being available as a basic rate tax reduction; this will then go down to 50% until 2019, followed by 25% until the start of the new tax year in 2020 when the new system will come into full force.
What Solutions are Available?
There are lots of ways landlords can work their way around this. For some, this, in addition to last year’s Stamp Duty rise, will mean the straight-forward solution of selling; however, for those who have larger property portfolios and are landlords by profession, this will not be an option. Owners of just one or two Buy-to-Let homes will have very little to be concerned about. Here are a few solutions that are available for the other big-time Buy-to-Letters:
Increase Rents
Although this is not ideal and will undoubtedly result in increased competition in the market, this is a feasible solution. According to a survey done by the Residential Landlords Association, two thirds of its members were expecting to increase their rents as a result of the new enforcement. Albeit, rents are on the rise across the country, so for many this will just be a case of adapting to the evolving economic climate as a whole rather than solely because of this change.
Switch Mortgages or Re-mortgage
Some property experts suggest switching to shorter-term, fixed rate deals for lower interest, whilst some are re-mortgaging altogether to find the best deal on the market. It will still mean having to succumb to the new changes, but it’s a way of cutting corners to increase profit margin, even if it’s just a slight increase.
Transfer Ownership to a Spouse
If your spouse pays a lower rate of tax, it is possible to transfer ownership of properties to them, so long as it doesn’t take them into that higher tax band, which will render the point moot. Even if it’s just one property, this balancing act may be worth doing.
Become a Company
This is amongst one of the most popular strategies investors have considered since the Stamp Duty rise last year, and will continue to be a viable option as the reality of the cuts to mortgage relief sets in. This may initially result in more costs, but could pay off in the long term.
Read more about the tax hikes and how to adapt with our Stamp Duty survival guide.
