Lee Sharpe considers the tax implications for landlords of buy-to-let properties after interest rates have risen significantly in little over a year.
The Bank of England base rate was a mere 0.1% in September 2021 and stayed there until the end of that year. At the time of writing (late September 2023) it is now 5.25%. Some of us are old enough to remember when mortgage rates reached more than 15% p.a. but I don’t think we have ever seen base rates rise by more than 5,000% in such a relatively short period of time.
What are the implications for a tax regime last reformed at a time when interest rates were immodestly modest, but borrowing was nevertheless still quite accessible?
Recap
As with so many tax travesties, we need briefly to cast our minds back to summer 2015, when Chancellor George Osborne, the hitherto largely unsung ‘Angel of Austerity’, announced a cunning plan supposedly to rein in buy-to-let (BTL) mortgage borrowing. It is arguable that the Prudential Regulation Authority’s revised criteria for lending to ‘portfolio landlords’ since 2016 have been more effective, but we are where we are.
The current regime disallows interest relief for income tax purposes – which might easily push the residential property landlord into a higher rate of tax – but then gives a 20% non-repayable tax credit (reduction) against their eventual liability. So long as they remain a basic-rate taxpayer, the ‘credit’ will suffice – usually. Otherwise, there is an effective tax penalty (ITTOIA 2005 s 272A et seq.). Of course, given that this regime applies only to income tax, corporate landlords (residential or otherwise) are unaffected.
Commercial lending rates have almost doubled to around 7% p.a. from around 4% p.a. in September 2022. We shall consider the tax implications for a BTL landlady.
Example 1: Effect of interest rate increase
Cassandra is a surgeon with a single residential rental property. She already pays 40% income tax on her salary. She clears £2,000 per month net rental income after agency and maintenance costs, with a £150,000 interest-only mortgage. Having fixed her finance costs around three years ago at 4% interest-only, she is now about to fix again for the next five years from March 2024, at a relatively eye-watering 8%:
Cassandra is being punished twice over:
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Her finance costs have doubled, so her real profit has fallen.
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The built-in tax penalty for the mortal sin of a BTL mortgage has also doubled.
Given that Cassandra’s residential letting finance costs are effectively ignored for tax purposes, the substantial real-world increase in mortgage interest rates has had no effect on her assessable income, against which the thresholds for student loans and child benefit clawback are measured (amongst others).
All other things being equal, Cassandra’s net-of-tax income from 2024/25 will be half what it was up to 2023/24 (and it was already 1/9th lower since 2016, thanks to the BTL tax adjustment before interest rates increased). But ‘all other things’ will likely not remain equal, as the strength of demand in the rental market means Cassandra will probably be able to increase her rent charge.
Hidden costs exacerbated
There are other traps lurking in the BTL tax regime, which can apply where the taxpayer’s investment income is significant. This is because the 20% tax ‘credit’ is available only when it may be applied to reduce tax on income that is not from interest or dividends.
The most likely victim will be someone who is retired or is otherwise largely reliant on investment income.
Example 2: Pensioner with rental income
Trevante has retired early after suffering from long COVID and, while waiting for his state pension to commence (and in the absence of state benefits due to his substantial capital means), his income is:
Private pension £6,000
Rental income £4,000 (after interest)
Dividend income £3,500
Suppose that Trevante’s BTL mortgage interest has increased in 2023/24 to £2,570. One might suppose that the disallowed interest of £2,570 would result in a tax reduction of £2,570 @ 20% = £514.
We might also expect Trevante’s income tax on dividends to amount to:
£3,500 - £1,000 dividend ‘allowance’ (2023/24) = £2,500 @ 8.75% = £218.75
So, the basic-rate tax ‘credit’, while non-repayable, should at least suffice to wipe out Trevante’s dividend tax bill. After all, the only reason Trevante even has a tax bill is because his BTL loan interest is added back so that his net rental income is deemed to be £6,570, and his personal allowance is thereby fully utilised against pension and rental income.
Unfortunately, the tax reduction is more complicated than this. The initial reducing amount to which the basic rate is then applied cannot exceed the individual’s ‘adjusted total income’. Broadly, adjusted total income is all incomes net of losses and personal allowance, etc., but excluding interest and dividend income (also excluding life assurance gains, accrued income profits and certain other incomes, in accordance with ITTOIA 2005, s 274AA).
In Trevante’s case, his non-interest, non-dividend income after disallowing rental finance costs is £12,570, so it is just covered by his tax-free personal allowance. His adjusted total income is £nil.
Therefore, the tax-reducing adjustment is restricted to £nil, and he does not get the benefit of any tax reduction at all; the liability on his dividend income is not ameliorated and the £218.75 is due in full.
Theoretically, any reducing amount that is unutilised like this is available to carry forward to reduce liabilities in future years. But in practical terms, there is a significant risk that non-savings incomes will not rise in future or that the rental business will cease, and such reductions will then be forfeit.
Questionable logic
The restriction of the tax reduction, so that it militates against dividend or interest income, is supposedly so that it will encourage BTL landlords to apply their savings or liquidate their share portfolios to pay down their BTL borrowings. Whether a person in Trevante’s position would be wise to reduce the diversity of their investment profile down to solely residential lettings is a matter for a qualified financial adviser.
But, given that we are in a period of high interest rates and high inflation, the likelihood is that Trevante’s share portfolio will carry an increasing capital gains tax burden.
Trevante may simply find it easier to charge higher rents to cover his increased tax costs.
Conclusion
BTL landlords were already reportedly leaving the market because of the increased effective tax cost of running a BTL portfolio. It follows that there is less rental accommodation to go around, but not necessarily fewer tenants. One might wonder if those who supported the idea of the 2015 punitive tax grab against ‘greedy landlords’ are now complaining that there are no longer so many rental properties on the market – or, for those properties that remain, the rents are becoming significantly more expensive.
