Sarah Bradford explains the rules governing tax relief for interest and finance costs.
Landlords whose current fixed-rate mortgage deals have come to an end are likely to be facing a hike in mortgage interest costs when they remortgage. For landlords with standard variable rate and tracker mortgages, interest costs have been rising steadily for some time.
When it comes to tax relief for mortgage and finance costs, all types of letting are not equal as the way in which relief is given and the amount of that relief depends on the type of letting.
Unincorporated landlords with residential lets
The rules governing relief for interest and finance costs incurred by unincorporated landlords with residential lettings (other than furnished holiday lettings) are less generous than for other types of lettings. Unincorporated landlords are no longer allowed to deduct their interest and finance costs when working out the profit for their property rental business. Instead, relief is given in the form of a tax reduction. Further, this is given at the basic rate of tax, regardless of the rate at which the landlord pays tax.
The approach is to work out the rental profit ignoring interest and finance costs, and calculate the tax on that profit. The tax figure is then reduced by the tax reduction for interest and finance costs. The reduction is 20% of the lowest of the following amounts:
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the landlord’s interest and finance costs;
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the profits of the property business after taking account of any brought forward losses; and
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the landlord’s adjusted net income (income after losses and reliefs but excluding dividend and savings income to the extent that it exceeds the landlord’s personal allowance).
The tax reduction is capped as it cannot create a tax refund.
Where it is not possible to deduct 20% of the interest and finance costs for the tax year (as this would create a tax refund) the unrelieved interest and finance costs are carried forward and taken into account in calculating the tax reduction for the following tax year.
Example 1: Calculation of relief for loan interest and finance costs
Adam is a residential landlord. In 2023/24, he incurs interest and finance costs of £30,000 in respect of his residential property portfolio. Before taking account of interest and finance costs, he makes a profit of £60,000 from his property rental business. He has no other income.
Adam’s tax liability before taking account of the tax reduction for interest and finance costs is £9,486 (20% (£60,000 - £12,570)).
The permitted tax reduction is the lowest of the following amounts:
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£6,000, being 20% of the interest and finance costs of £30,000;
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£12,000, being 20% of the property business profits of £60,000; and
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£9,486, being 20% of Adam’s adjusted net income of £47,430.
The tax reduction is therefore £6,000 and Adam’s tax liability is £3,486 (£9,486 - £6,000).
Example 2: Loan interest and finance costs carried forward
Barbara is also a residential landlord. In 2023/24, she incurs interest and finance costs of £24,000. Before taking account of the interest and finance costs, the profit from her property rental business is £30,000. She has no other income.
Barbara’s tax liability before taking account of the tax reduction for interest and finance costs is £3,486 (20% (£30,000 - £12,570)).
The permitted tax reduction is the lowest of the following amounts:
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£4,800, being 20% of the interest and finance costs of £24,000;
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£6,000, being 20% of the profits of the property rental business; and
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£3,486, being 20% of Barbara’s adjusted net income of £17,430.
The tax reduction is therefore £3,486, which reduces Barbara’s tax bill to nil.
However, as the maximum tax reduction is less than 20% of Barbara’s interest and finance costs, Barbara is unable to obtain relief in full in 2023/24 for the interest and finance costs incurred in that tax year. She is only able to obtain relief for £17,430 of those costs, leaving interest and finance costs of £6,570 unrelieved.
The unrelieved costs are carried forward to 2024/25 and added to the interest and finance costs incurred in that year when calculating the tax reduction.
Unless landlords can increase their profits to cover rising interest costs, they may increasingly find that they are unable to relieve interest and finance costs in full. While unrelieved amounts can be carried forward, these will only be relieved where the landlord’s profits and adjusted net income are sufficient to allow a tax reduction of 20% of the total unrelieved interest and finance costs. Where this is not the case, relief for interest costs is effectively put on hold.
Furnished holiday lettings
The interest rate restriction for residential lettings does not apply to furnished holiday lettings. Unincorporated landlords with furnished holiday lettings can still deduct the full amount of the interest and finance costs they incur in calculating the profits of the furnished holiday lettings business, even if this means that the business makes a loss.
As relief is given as a deduction in calculating profits, relief is given at the landlord’s marginal rate of tax rather than being restricted to the basic rate, as is the case for residential lets.
Example 3: Interest and finance costs: Furnished holiday lettings
Chris has a number of furnished holiday lettings. In 2023/24, he incurs interest and finance costs of £30,000. Before taking account of these costs, he makes a profit of £60,000 from his furnished holiday lettings business. Chris has other income from an interior design business of £70,000.
The interest and finance costs are deducted in full in working out the profits of his property rental business. Chris therefore makes a profit of £30,000 for 2023/24. As Chris is a higher-rate taxpayer, he pays tax on those profits at a rate of 40%. Consequently, relief for the interest and finance costs is obtained at his marginal rate of 40% and is worth £12,000 (40% of £30,000).
Had Chris let his properties as residential lettings, the interest relief would only have been worth £6,000 (20% of £30,000).
Commercial landlords
Landlords who let commercial properties are not affected by the interest relief restriction and continue to be able to deduct interest and finance costs in full when calculating the profits of their property rental business. The position is as for furnished holiday lettings. The landlord can deduct their interest and finance costs in full, even if this creates a loss. The relief is given at the landlord’s marginal rate of tax.
Corporate landlords
The interest rate restrictions do not apply to corporate landlords, even where the lettings are residential lettings. The company can deduct the interest and finance costs in full when calculating the profits chargeable to corporation tax. Relief is therefore given at the rate at which the company pays corporation tax, which from 1 April 2023 is at a rate of between 19% and 25%.
Although costs are deductible in full when the property business is operated as a company, unless the company pays corporation tax at a rate in excess of 20%, the rate of relief is lower than that obtained as a tax reduction by an unincorporated landlord.
Where the property rental business is operated as a company, the landlord will need to extract the profits if these are to be used for personal use. This may involve additional costs.
Choose your lettings
As outlined above, the way in which relief is given for interest and finance costs depends on the type of letting. In this context, residential lettings are very much the poor relation.
In a climate of rising interest costs, landlords may wish to review their letting portfolio and consider whether other types of lettings may be more beneficial. For example, depending on the area, an unincorporated landlord letting residential property may decide to let the property as a furnished holiday letting instead. This will allow the landlord to deduct their interest and finance costs in full and obtain relief at their marginal rate of tax.
The interest relief rules for residential lettings do nothing to help the current shortage in rental accommodation, and may push landlords into other types of lettings, exacerbating the shortage.
Practical tip
Consider whether a different type of letting will provide a better rate of relief for interest and finance costs than residential lettings.
