Understanding the impact on taxpayers of the Chancellor’s move to offset mortgage interest at basic rate only.
In his summer budget George Osborne announced that landlords will only be able to offset mortgage interest at the basic rate of tax (20%) by 2020. This will be introduced gradually from 6 April 2017. The restriction will not apply where the property meets all the criteria of a furnished holiday letting. Guidance about accommodation that qualifies as a FHL can be found here.
Current situation
Landlords pay income tax on their rental profit by declaring the amount they earn on a self-assessment tax return. The landlord can deduct mortgage interest (plus associated costs like arrangement fees) along with all other costs before determining the taxable profit. Tax is then charged on the rental profit applying the normal income tax bandings – 20% for basic rate taxpayers, 40% for higher rate taxpayers and 45% for additional rate taxpayers.
New rules
Landlords will no longer be able to deduct all of their finance costs from their property income to arrive at their rental profits. The relief in respect of finance costs will be restricted as follows:
| 2017/18 | 75% allowed | 25% basic rate |
| 2018/19 | 50% allowed | 50% basic rate |
| 2019/20 | 25% allowed | 75% basic rate |
| 2020/21 | Nil | 100% basic rate |
Example:
Rental income £10,000
- allowable expenses not including finance cost £2,000
- finance cost £3,000.
The tax position for a basic rate taxpayer will be as follows:
| Profit before finance cost | Finance cost allowed | Taxable profit | Tax at basic rate | Tax relief on finance cost | Total tax due | |
| Current | 8,000 | 3,000 | 5,000 | 1,000 | Nil | 1,000 |
| 2017/18 | 8,000 | 2,250 | 5,750 | 1,150 | (150) | 1,000 |
| 2018/19 | 8,000 | 1,500 | 6,500 | 1,300 | (300) | 1,000 |
| 2019/20 | 8,000 | 750 | 7,250 | 1,450 | (450) | 1,000 |
| 2010/21 | 8,000 | Nil | 8,000 | 1,600 | (600) | 1,000 |
While the total amount of tax due has not changed, this does not mean that the landlord’s tax position is unaffected. As taxable profit has increased from £5,000 to £8,000, it is possible that a taxpayer who is currently at the limit of the basic rate band might find himself in a higher rate tax position when nothing else has actually changed.
The tax position for a higher rate taxpayer will be as follows:
| Profit before finance cost | Finance cost allowed | Taxable profit | Tax at 40% rate | Tax relief on finance cost (20%) | Total tax due | |
| Current | 8,000 | 3,000 | 5,000 | 2,000 | Nil | 2,000 |
| 2017/18 | 8,000 | 2,250 | 5,750 | 2,300 | (150) | 2,150 |
| 2018/19 | 8,000 | 1,500 | 6,500 | 2,600 | (300) | 2,300 |
| 2019/20 | 8,000 | 750 | 7,250 | 2,900 | (450) | 2,450 |
| 2010/21 | 8,000 | Nil | 8,000 | 3,200 | (600) | 2,600 |
As expected, a higher rate taxpayer ends up paying more tax as relief for finance costs is restricted to the basic rate.
The company option
As companies continue to benefit from the full relief, it might be possible for landlords to consider transferring properties into limited companies. While corporation tax is due to fall to 19% in 2017 and 18% in 2020, when investing through a company income can only be paid out to the shareholders as a dividend.
From next April, directors can receive £5,000 annually tax-free, with higher rate taxpayers paying a 32.5% dividend tax on any income above this amount. If you’re considering this option, proceed with caution. We will publish a further article on this subject next month.