Tax Relief On Your Home Mortgage (Part 2)

In the first article, we looked at the principles of how to get tax relief on your mortgage. This article will in turn look at the impact of the new rules for restricting tax relief on residential lettings, in this context. 

From April 2017, tax relief for interest will be restricted. This means that the maximum relief will be just the basic rate of tax, of 20%. The new regime will disallow the interest cost against rental profits, and then give a special corresponding 20% tax credit against the increased liability. Those taxpayers who remain subject only to basic rate tax of 20% will be unaffected, because the disallowed interest will cost tax at 20%, and will be fully offset by the new credit. But those who pay tax at higher rates – 40% or 45% – will lose out at a rate of 20% or 25% respectively, because the new credit will not be sufficient to offset the full tax rise. 

Eric has a modest residential property portfolio, kick-started several years ago by a property inherited from his late parents. While he has since used the property as collateral for other rental properties, the borrowings are more than offset by the value of those later properties as introduced to the rental business. Netting off the borrowings against the aggregate of those original values leaves Eric with £120,000 surplus historic capital in his rental business. His portfolio has grown in value, and could now easily support further borrowing of £120,000. His private mortgage is £150,000. 

Let us assume for simplicity that Eric’s private mortgage is payable at a rate of 5%, and Eric can borrow against his buy-to-let (BTL) portfolio at 5%. At the moment, his home mortgage is costing him £7,500 a year, interest-only. He has no letting costs other than his mortgage interest.

Let’s also assume that Eric has modest other income sources of £12,000, (basically, enough to use his tax-free personal allowance). Eric’s results if he does nothing are as follows:

The residential mortgage disallowance is being introduced in four equal tranches from 2017/18 through to 2020/21. Each year, the disallowance increases by a quarter and so does the 20% tax credit. Eric is a 20% taxpayer, so the new tax credit is sufficient to offset all of his increased tax bill for letting.

If we now assume that Eric instead borrows a further £120,000 at 5% interest-only, he is entitled to withdraw those funds and use them to reduce his home mortgage to just £30,000. His BTL mortgage interest will increase by £6,000 a year, but his personal mortgage will decrease by the same amount:

As we can see by comparing ‘with extra BTL mortgage’ and ‘without extra BTL mortgage’ above, if Eric is able to claim the bulk of his private mortgage interest through his rental business, then he is better off despite the changes. In this case, he is £1,200 better off a year, which equates to a 20% tax saving on the adjustment to his private mortgage interest:

£7,500 - £1,500 = £6,000 @ 20% = £1,200

Let’s take a similar example of Eric’s best friend, Ernie, who also has a remarkably similar residential property portfolio. Ernie, however, is a computer consultant and is already comfortably a 40% higher rate taxpayer. If we look at the scenario without re-financing his private mortgage first:

Let’s now assume that Ernie also moves £120,000 of private borrowing against his BTL portfolio – which is allowed because, like Eric, he has introduced sufficient capital value over the years to cover this additional borrowing:

The result is that Ernie still saves £1,200 by using this approach, once the new regime is fully implemented in 2020/21. This is again down to saving 20% tax on a further £6,000 of mortgage interest through his BTL portfolio. It might seem surprising that Ernie saves the same amount of tax as Eric. But note that, before the new tax restriction, Ernie’s saving would have been at the full 40% rate on the interest adjustment: £7,500 - £1,500 = £6,000 @ 40% = £2,400

In fact, this is evident when comparing the position in 2016/17 between Eric and Ernie – before the interest restriction starts to bite. So Ernie has indeed lost out because the additional saving ultimately gets restricted to just 20% instead of 40%.

It is reassuring to see that Ernie will still save tax if he is able to re-arrange his finances. Based on the above examples, higher rate taxpayers will want to make these adjustments soon, so as to maximise the savings before the new regime is fully in place. Care is also needed to ensure that the maths works on a case-by-case basis; if the current private mortgage interest cost is significantly lower than the rate one might achieve in a BTL mortgage, it may be better sticking with what you’ve got, despite passing up the tax savings. Also, Ernie should look at re-structuring the finance alternatively in his computer consultancy, which could potentially save tax at his full marginal rate of 40%, bypassing the residential interest restriction.