Today marks the start of a new tax year. This one will be particularly significant for existing landlords as the mortgage interest relief changes start to come into play.
Previously, finance costs would be deducted from a landlord’s income to calculate their profit, just like any other business. They would then pay tax on this profit at the appropriate rate.
Let’s say a landlord has rental income of £30,000 per year with mortgage interest of £25,000. Currently this would mean a £5,000 profit, which the landlord would pay tax on at their normal rate i.e.
Basic tax-rate payers @ 20% = £1,000
Higher tax-rate payers @ 40% = £2,000
Additional tax-rate payers @ 45% = £2,250
However, in the 2015 Summer budget it was announced that landlords will lose the right to deduct their mortgage interest costs from their income. Instead, the amount you can offset will gradually fall over the next few years, until it is completely replaced from the 2020/21 tax year with a 20% tax ‘credit’.
That same landlord as earlier, with £30,000 in rental income and £25,000 of mortgage interest, will now have to pay tax at their taxable rate on the full £30,000 income before deducting just 20% of the mortgage interest.
This should mean there is no effect to a basic-rate taxpayer, as they would still pay £6,000 of tax (20% of £30,000) before recouping £5,000 (20% of £25,000) as a tax credit. They might, however, find that the significant increase in their taxable income will push them into a higher tax band; which will be affected by the changes.
Higher tax-rate payers will be lumbered with a £12,000 tax bill (40% of £30,000) before recouping that same 20% tax credit i.e. £5,000; resulting in a net tax bill of £7,000 – more than triple what they would pay now and £2,000 more than they have made in profits!
It gets even worse for additional tax-rate payers, as they would be faced with a tax bill of £8,500 when the new system comes into full force in 2020/21 (nearly four times as much as now!).
Meanwhile those without mortgages won’t be affected and nor will large corporations, leading many landlords to complain that the wealthy are unaffected by the changes, whilst the already squeezed middle are having their purses raided both unexpectedly and unfairly.
Some landlords have set up a company to eliminate the impact of the new tax system, as companies can still offset all of their finance costs. With corporation tax dropping to 17% by 2020 this could be a smart move for many, but it needs to be weighed up with possible capital gains tax liabilities if transferring existing properties as HMRC deems this to be a ‘sale’ to the company. The same applies if trying to transfer property to a spouse or partner who is in a lower tax-band.
The impact of all this is likely to translate into some landlords selling up, alongside fewer people entering the market. The resulting drop in the supply of rental properties, coupled with landlords needing to earn more to make the venture worthwhile, suggests rents are likely to increase.
It is perhaps more important than ever to get good advice not only in regards to what property to buy but also how to buy it. I’m happy to point you in the right direction in regards to both questions if you’d like to give me a call.