Buy-to-let property can be a good earner, but as the owner of BTL have you understood and planned for the implications of the change from deduction of interest on property to one of tax relief correctly?
From 2016/17, deduction of interest payments on property loans will change to tax relief which will be phased relief and not full impact on relief restriction will be seen. From 2020/21 relief on interest will be restricted to basic rate. This means that a property loan that is currently paid at the taxpayers marginal rate of tax of 20% (say of a £100 loan @ a cost of £55), after 2020 will cost £80 as tax relief. If you haven’t planned for this change, then even borrowing at a modest level might could end up that you pay more in tax than you make in profit.
Three examples illustrate what happens to Amy, Boris, and Belinda with a property worth £250,000. They all receive rental income of £17,000 before letting and other costs of £2,000, and have a mortgage of £180,000 with an interest cost of £9,000; thus profit before rental interest is £15,000 and after interest, £6,000.
Example 1
Amy is self-employed and has taxable profit of £25,000. From the illustration below, you can see that there is no change in Amy’s overall tax liability as a basic rate taxpayer. If Amy paid tax through PAYE, however, she would have already paid £2,600, leaving her with a £1,200 tax bill to pay on rental income – i.e. 20% of his taxable rental profit of £6,000.
| % Tax | Current Rules | 2020 | |||
| £ | Tax | £ | Tax | ||
| Salary | £25,000 | £25,000 | |||
| Taxable rental profit | £6,000 | £15,000 | |||
| Taxable income / profit | £31,000 | £40,000 | |||
| Tax band | Tax band | ||||
| Tax at | 0% | £12,000 | £0 | £12,000 | £0 |
| 20% | £19,000 | £3,800 | £28,000 | £5,600 | |
| Less tax relief on interest | 20% | £9,000 | -£1,800 | ||
| Total tax | £3,800 | £3,800 | |||
Example 2
Boris earns a salary of £75,000. From the illustration you can see that Boris’s total tax bill has risen by £1,800 due to the restriction on interest relief to 20% on £9,000 of interest expense (£9,000 x 40% / 20%). Boris has already paid £17,600 PAYE and so the tax on his net rental income of £6,000 has increased from £2,400 (£20,000 / £17,600) to £4,200 (£21,800 / £17,600). Boris is hit with 70% on his net profit!
| % Tax | Current Rules | 2020 | |||
| £ | Tax | £ | Tax | ||
| Salary | £75,000 | £75,000 | |||
| Taxable rental profit | £6,000 | £15,000 | |||
| Taxable income / profit | £81,000 | £90,000 | |||
| Tax band | Tax band | ||||
| Tax at | 0% | £12,000 | £0 | £12,000 | £0 |
| 20% | £38,000 | £7,600 | £38,000 | £7,600 | |
| 40% | £31,000 | £12,400 | £40,000 | £16,000 | |
| Less tax relief on interest | 20% | £9,000 | -£1,800 | ||
| Total tax | £20,000 | £21,800 | |||
Example 3
Belinda believes that she will not be affected by the change, since her salary is £43,000, which together with her rental profit of £6,000 leaves her below the higher rate income threshold of £50,000. Poor Belinda is hit by an additional £1,600 tax bill as her gross income including her rental profit before tax deduction is £58,000. Belinda pays additional tax of £8,000 x (40% / 20%).
| % Tax | Current Rules | Budget Proposals | |||
| £ | Tax | £ | Tax | ||
| Salary | £43,000 | £43,000 | |||
| Taxable rental profit | £6,000 | £15,000 | |||
| Taxable income / profit | £49,000 | £58,000 | |||
| Tax band | Tax band | ||||
| Tax at | 0% | £12,000 | £0 | £12,000 | £0 |
| 20% | £37,000 | £7,400 | £38,000 | £7,600 | |
| 40% | £0 | £0 | £8,000 | £3,200 | |
| Less tax relief on interest | 20% | £9,000 | -£1,800 | ||
| Total tax | £7,400 | £9,000 | |||
Option 1. As there is no current proposal for restricting the deduction of financing costs within companies, you could transfer property to a limited company or consider buying property with a buy-to-let mortgage through a limited company.
If you take this option you are allowed a full deduction of interest and other finance costs from the rents received, but the transition will involve Capital Gains Tax (CGT) and stamp duty land tax (SDLT) costs. The mortgage provider will also have to agree to the transfer of loans to a company and may apply a higher rate of interest on a corporate loan.
Options 2 and 3. Alternatively, you could sell residential property and reinvest in commercial buildings or let out the residential property as a furnished holiday let.
Additional expense: CGT liabilities and land duties
The sale of property or transfer into a company controlled by you will result in CGT unless the gain can be covered by a relief, or be deferred using the enterprise investment scheme (EIS) or social investment tax relief (SITR). An investment under SEIS could also be used to exempt up to £50,000 of gain a year, where the maximum permitted (£100,000) is invested in SEIS shares.
Alternatively, for a small number of properties carrying relatively low gains you could look at selling them gradually, with any gain covered by your annual exemption for each year (£11,100 for 2015/16). Any property held jointly can take both owners’ annual exemption against the gain.
If all the property is transferred to a company in one go, in return for shares, incorporation relief could be used to the value of those shares. No claim is required as incorporation relief is applied automatically if all the conditions are met; however, a full disclosure on the tax return for the relevant year should be made.
Land duties
Where the properties are transferred to a company, the funds to pay the SDLT or LBTT charges must be found by the company.
If the property is held by a family, partnership there may be relief from SDLT / LBTT on the incorporation of that partnership. There is also an averaging relief that can be used to reduce the SDLT when there is acquisition of multiple dwellings.
No easy answer and no quick fix
In conclusion, it is clear that tax planning is essential between now and 2020 for existing or aspiring BTL property owners. Over the following two tax years, from TODAY, there is time to discuss your present circumstances and plans for the future with your account manager. It is not advisable to wait and then make decisions in a rush. Ring DNS today to discuss the implications of the change from deduction of interest on property to one of tax relief and really understand how it might affect you. Then it will be possible to start putting in place a plan gradually between now and 2020.
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