Sarah Bradford looks at the tax implications of refinancing let properties and the extent to which tax relief is available on borrowings.
Recent house price increases may have increased the equity that landlords have in their rental properties. This provides the opportunity to extract some of that equity and use it either to fund a deposit on another property or for personal use.
With interest rates rising, landlords looking at refinancing opportunities will want to be clear on the extent to which tax relief is available for increased borrowing costs.
Basic rule
Tax relief is available for finance costs to the extent that they are incurred wholly and exclusively for the purposes of the property rental business. The way in which relief is given depends on whether the landlord runs the property business as an unincorporated business or as a company. Where the property business is an unincorporated business, different rules apply to furnished holiday lettings and residential lettings. No tax relief is available for capital repayments.
Where a loan is used either directly or indirectly to purchase an investment property which is let out, the basic rule is that interest relief is available on borrowings up to the value of the property when it is first let out. In a straightforward case, where a landlord buys a property to let as a residential letting with a cash deposit and a mortgage, tax relief will be available for the interest on the mortgage.
Example 1: New landlord
Billy has inherited some money from his grandmother and wishes to purchase an investment property to let out. He buys a property for £200,000, which is financed by a cash deposit of £50,000 and a mortgage of £150,000. He has no other borrowings.
He immediately lets the property out. He is able to claim tax relief for the mortgage interest.
Loan not secured on buy-to-let
To qualify for tax relief, the loan does not need to be secured on the let property. The basic rule that relief is available on borrowings up to the value of the property when it was first let holds true.
If, for example, a prospective landlord remortgages their main residence to release equity to purchase a buy-to-let property, relief on the loan is available up to the value of the investment property when it was first let. Although the loan is not secured on the investment property, the funds were borrowed wholly for the purposes of the property rental business to provide the capital necessary to purchase the rental property.
Example 2: Remortgaging main residence
Janet has lived in her main residence for a long time and it has appreciated significantly since she purchased it. She wishes to buy an investment property to provide additional income during her retirement.
She remortgages her main residence to release equity of £250,000, which she invests in a property costing £275,000, providing the balance from her savings. Although the loan is not secured on the investment property, the purpose of the borrowings is to fund its purchase. Consequently, interest relief is available for interest on the full loan of £250,000.
Borrowing exceeds the value of the property
As the basic rule caps the borrowing to the value of the property at the time it is first let, if a loan is taken out for more than this, relief will not be available for the interest on the total amount of the borrowings.
Example 3: Pro-rata tax relief
Peter has a mortgage of £400,000 secured on his main residence. He purchases an investment property for £150,000. He lets the property immediately.
Although he did not take out the loan to buy the property, he invests capital to the tune of £150,000 in its purchase and is able to claim tax relief on borrowings to cover this. Consequently, he is able to claim tax relief for 37.5% of the loan interest paid on the mortgage of £400,000 (150/400 x 100%).
Property not let immediately
The relief cap applies to the value of the property when it was first let, not its purchase price.
Consequently, where a property is not let immediately and has appreciated in value by the time that it is first let, relief is available for interest on borrowings in excess of the initial purchase price.
Example 4: Increase in property value
Ali buys a flat in 2016 for £140,000 which he lives in as his main residence. He has a mortgage of £100,000 on the flat. After getting married, he buys a house costing £500,000 on which he has a mortgage of £250,000. After moving into his new home he lets out the flat, which is now worth £220,000. At that time, the mortgage outstanding on the flat is £70,000.
Although the mortgage on the flat is only £70,000, Ali’s total borrowings are £320,000. He is able to claim tax relief for borrowings of £220,000, being the value of the flat when it was first let out. Consequently, the interest on the flat mortgage plus that attributable to £150,000 of the house mortgage (60%) is eligible for relief.
Releasing equity to expand portfolio
To build up a property portfolio, a landlord may remortgage let properties when they have increased in value to provide funds to use as a deposit to buy additional properties to let.
Where this strategy is employed, the basic rule remains, and interest relief is available on loans to the total value of the properties when first let.
Example 5: Growing a property portfolio
Liza has two properties that she lets out. She purchased the first one in 2010 for £150,000 and let it immediately. It is now worth £400,000. The second property was purchased in 2017 for £220,000. It is now worth £350,000. It, too, was let immediately. She has a mortgage of £170,000 on that property.
She remortgages the first property for £300,000, clearing the original mortgage of £100,000 and releasing funds of £200,000, which she uses to fund further properties. In each case, she puts down a deposit of £100,000. She takes out a mortgage of £175,000 on one of the properties and a mortgage of £250,000 on the other property. Both are let immediately, valued at their purchase prices of £175,000 and £350,000, respectively.
Her property portfolio and borrowing are as follows:
|
Property |
Value when first let |
Current value |
Borrowings |
|
1 |
£150,000 |
£400,000 |
£300,000 |
|
2 |
£220,000 |
£350,000 |
£170,000 |
|
3 |
£275,000 |
£275,000 |
£175,000 |
|
4 |
£350,000 |
£350,000 |
£250,000 |
|
Total |
£995,000 |
£1,375,000 |
£895,000 |
As her total borrowings (£895,000) are less than the total value of her properties when first let (£995,000), she can obtain tax relief on the full amount of the borrowings. It does not matter that the mortgage on property 1 (£300,000) is more than the value of that property when it was first let. The property business is considered as a whole.
Releasing equity for private purposes.
It is not essential to use equity released by refinancing for the purposes of the property rental business for interest relief to be available. The equity released can be used outside the business.
Again, the basic rule applies and interest relief is available for borrowings to the value of the property or properties when first let.
Example 6: Buying a new car
Gabe purchased a cottage for £300,000 in 2018, which he lets out as a furnished holiday let. The property was funded with savings of £80,000 and a mortgage of £220,000. The cottage is in a popular holiday area and is now worth £500,000. He wishes to take advantage of the increase in value to release equity of £50,000 to buy a new car.
As the total borrowings of £270,000 are less than the value of the cottage when first let (£300,000), interest relief is available in full. It does not matter that he uses the equity released by remortgaging for non-business purposes.
Mechanism of securing interest relief
Where the property is a residential let and the property rental business is an unincorporated business, interest relief on qualifying borrowings is given as a tax reduction at the basic rate. This means that for every £100 paid in qualifying interest, the tax payable on the property rental profits is reduced by £20. However, the reduction is capped at the amount of the tax due on the rental profits, with any unrelieved interest being carried forward.
For furnished holiday lettings, commercial lets and property companies, qualifying interest costs can be deducted in working out the taxable rental profit.
Practical tip
Landlords looking to refinance their investment properties may be able to benefit from tax relief on new loans, even if equity is released for personal use.
