Sunday, 14 February 2016
If you are a landlord then you may be confused by the new HMRC rules on mortgage interest tax relief, introduced in the July 2015 budget. The chancellor said that higher rate taxpayers would be limited to basic rate tax relief on their mortgage interest payments. This system will be fully in place by 2020 but will be phased in between now and then.
Currently landlords can deduct their entire mortgage interest cost from their rental income when working out what their rental profit is (on which they pay tax). As such, a £3,000 mortgage interest bill can cut the tax bill of a higher rate taxpayer by £1,200, vs only £600 for a basic rate taxpayer.
The new rules do away with this differential. They are a bit confusing but work as a 3 step process that will now apply to all landlords, regardless of what tax rate they pay.
The current system:
Lets take the example of a landlord with buy-to-let rental income of £5,000 and mortgage interest of £3,000. Under the current system his rental profit is £2,000. If he is a basic rate taxpayer he pays £400 tax on this, vs £800 for a higher rate taxpayer. As such, a basic rate taxpayer makes a £1,600 net profit (after tax), while a higher rate taxpayer makes a £1,200 net profit.
The new rules (fully in place from 2020):
1) stop allowing mortgage costs to be deducted when calculating profit (so the “profit” in the example about would be £5,000 regardless of what tax rate you pay, which could push you into the higher rate tax bracket)
2) work out what tax is due on that profit (£1,000 for basic rate taxpayer, £2,000 for a higher rate taxpayer) –remember that because your profit is now higher you may have been pushed into the higher rate tax bands.
3) reduce that tax bill by an amount equal to 20% of the mortgage cost (£600 for everyone)*
So now the tax bill for a basic rate taxpayer is £400 (same as before the change) but the tax bill for a higher rate taxpayer rises from £800 to £1,400 (OUCH).
As such, the basic rate taxpayer still makes a £1,600 return on his mortgage portfolio after mortgage interest is taken into account, but the higher rate taxpayer sees his return shrink from £1,200 to £600.
Does this make owning rental properties not worthwhile for a higher rate taxpayer? Not necessarily, but it certainly hurts.
One avenue open to buy-to-let investors is to own properties via a company, but that is another issue that we will deal with separately (don’t get us started on the stamp duty and capital gains tax implications ….).