Jennifer Adams considers various options for financing a buy-to-let property and the tax implications for each.
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The most straightforward method of financing a buy-to-let property is via the use of the landlord's own resources, if possible. Savings account interest rates are currently hovering around the 5% mark (with a return after basic rate tax of 4%: or 3% for higher-rate taxpayers) and the more cash invested in a rental property, the higher the percentage of return.
The downside of using your own cash is the lack of flexibility as the money will be tied up for the long term until the property is sold or remortgaged. Therefore, the majority of buy-to-let investors use a combination of their own resources and mortgages.
Remortgage other rental properties
HMRC's Business Income Manual at BIM45700 (“Specific deductions – interest: Withdrawal of capital from a business”) confirms that where a proprietor of any business finances the capital of that business with a mortgage, the interest is allowable against the profit made. HMRC views renting out property as a ‘business’, the ‘capital’ investment being the property itself. HMRC is more interested in the purpose of the original loan and not the individual asset against which the loan is secured.
Therefore, should the owner with more than one rental property remortgage that other property, withdrawing some of the capital raised, the interest remains allowable (subject to the tax 'cap') because the original reason for the mortgage remains – namely to fund the transfer of capital into the business.
Portfolio lending
Two or more properties owned by one landlord are generally referred to as a property ‘portfolio’. With portfolio lending, the properties in the ‘portfolio’ are treated as being held within a single account. The individual properties may have separate mortgages with different interest rates charged but the value of such a ‘portfolio’ account is that it is treated as a single account regardless of the number of properties.
The rental income and loan-to-value are averaged across the whole mortgage portfolio enabling advantage to be taken of any excess rental income or equity in the business as a whole. This excess can then be used to support the purchase of other properties. For example, should the value of six properties total £2m and the total mortgages outstanding thereon is £1.7m, there is a difference of £300,000 overall. This amount will not be the equity in any one property, but the total equity amount spread over the whole portfolio of properties. Therefore £300,000 will be the amount of credit available for further investment.
Financing lenders of such products usually only consider portfolios valued at between £500,000 and £10m and expect rental income to be in the region of 130% of the loan repayments. The interest rate charged is often more competitive than rates on smaller individual mortgages because the loan is more akin to a credit facility. However, you are buying flexibility as well as knowledge that tax credit relief is available to the maximum allowed.
The availability of such a stream of credit enables an investor to make bids on the purchase of properties such that there is no need to apply for finance each time a portfolio expansion is required.
Release of equity from main residence
The loan need not be secured on the let property to qualify for interest tax credit relief. For the small-time investor with sufficient equity in their main home, one option may be to release equity from that main home and use this to invest in the buy-to-let property.
A loan secured on the borrower’s main principal private residence generally attracts lower interest rates and arrangement fees than a buy-to-let mortgage secured on the rental property. Should a main property mortgage or fixed mortgage deal be coming to an end, the property may have increased in value, so increase the mortgage and use that increase to reinvest in a buy-to-let. Although the loan is not secured on the property, the funds are being borrowed to provide the property rental business with the capital necessary to purchase the rental property; therefore, interest tax relief is allowed.
Using a personal pension fund
There are two ways that a self-invested personal pension (SIPP) can be used to buy property. One is to withdraw the cash once access is permitted (normally from the age of 55 onwards) and the other is for the SIPP to purchase the property itself. However, only commercial property can be purchased this way; the purchase of residential property is not permitted.
One advantage of a SIPP purchase is that the rent received adds to the value of the pension and is not subject to income tax. The rental income is also not classed as a pension contribution and therefore additional personal contributions can be made. In addition, there will be no capital gains tax liability on any capital growth on sale and the sale proceeds are added back into the pension scheme value. Using these reliefs, a business owner can buy the business premises within a SIPP, the business pays rent, receiving tax relief thereon and the rental income is tax-free as is any increase in the property value.
In addition, as pensions typically fall outside of the estate there should be no liability to inheritance tax.
Interest tax credit relief
Where a loan is used either directly or indirectly to purchase a buy-to-let property which is subsequently let, interest tax credit relief is available at 20% basic rate up to the property value when first let, subject to the tax credit 'cap'.
If personal borrowing rather than cash is used for the deposit, the interest charged on this loan can also be included in the tax credit relief calculation as the loan would have been taken out and used ‘wholly and exclusively’ in connection with the rental property.
Buy-to-let mortgages are designed specifically for purchasing rental properties and, typically, lenders finance up to 60% with the balance coming from the landlord's other resources, whether personal borrowing or cash. Interest rates on buy-to-let mortgages are generally higher than residential mortgages, with lenders usually requiring expected rental income to be a multiple (e.g., 125-145%) of the mortgage repayments.
Tax credit 'cap'
The basic rule is that borrowing is 'capped' to the property's value at the time it is first let; if a loan is taken out for more than this amount, relief will not be available for the interest on the total amount of the borrowings.
The basic rate reduction or tax credit is ‘capped’ at the lower of the:
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loan interest claimed in the tax year;
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profits of the business for the tax year; and
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adjusted total income (after losses and reliefs but excluding savings and dividend income, which are taxed as top-slices) exceeding the annual personal allowance.
Should the tax credit exceed the tax liability, it is capped at that amount so as to reduce the tax bill to nil. Any amount not utilised in one tax year is carried forward and added to the loan interest figure for the following year. The tax credit is then calculated using the balance of interest not utilised brought forward plus the current year's loan interest.
No tax deduction is allowed if a loss has been made. Instead, the unused amount for that year is carried forward and included in the following year's calculations.
Practical tip
Tax credit for interest paid is given to the extent that the borrowings are used for the property rental business. Care should be taken, as it may be difficult to determine the extent to which the interest is tax deductible where the borrowings are used for both business and non-business purposes.
