Until 5 April 2017, individual landlords could deduct their costs, including mortgage interest relief, without restriction, from their profits for tax purposes. Since ordinary homebuyers have not been able to claim tax relief on mortgage payments for many years, landlords were at a considerable advantage where finance costs were concerned. Indeed, wealthier landlords could receive tax relief of 40%, and in some cases 45%, on their interest payments.
The government acknowledged the unfairness of this anomaly, and Finance (No 2) Act 2015 (s 24) subsequently set a schedule in motion for gradually phasing in restrictions on the amount of tax relief landlords can claim for their finance costs. Once the restrictions are fully implemented, tax relief will be restricted to 20% for all individuals.
Who is affected?
- The new rules only apply to individuals with residential property businesses.
- They do not apply to companies.
- They do not apply to land and property dealing or development businesses, commercial lettings or furnished holiday lettings.
Calculating the reduction
The reduction in relief is the basic rate value (currently 20%) of the lower of:
- finance costs: costs not deducted from rental income in the tax year (this will be a proportion of finance costs for the transitional years) plus any finance costs brought forward;
- property business profits: the profits of the property business in the tax year (after using any brought forward losses); or
- adjusted total income: the income (after losses and reliefs and excluding savings and dividends income) that exceeds the personal allowance.
The tax reduction cannot be used to create a tax repayment.
If the basic rate tax reduction is calculated using the ‘property business profits’ or ‘adjusted total income’ then the difference between that figure and ‘finance costs’ is carried forward to calculate the basic rate tax reduction in the following years.
Landlords will still be able to deduct some of their finance costs when calculating taxable property profits during the transitional period. These deductions will be gradually withdrawn and replaced with a basic rate relief tax reduction:
- in 2017/18 the deduction from property income (as previously allowed) was restricted to 75% of finance costs, with the remaining 25% being available as a basic rate tax reduction;
- in 2018/19, 50% finance costs deduction and 50% given as a basic rate tax reduction;
- in 2019/20, 25% finance costs deduction and 75% given as a basic rate tax reduction; and
- from 2020/21 all financing costs incurred by a landlord will be given as a basic rate tax reduction.
Impact on taxpayers
Some landlord taxpayers may find that, once finance costs are disallowed in their property business accounts, they suddenly find themselves liable to higher rate income tax. Overall tax liability for a particular tax year depends on total income, i.e. including all other income and the amount of finance costs that are added back. If a landlord does become a higher rate taxpayer after arriving at rental profits, the restrictions will, of course, mean that he will not be entitled to higher rate tax relief on the finance costs.
An increase in property income profits will generally lead to an increase in a taxpayer’s total income for tax purposes and this may have a knock-on effect in other areas, depending on personal circumstances. In particular, this may be the case where tax credits are claimed, or where an increase in income takes the taxpayer over the income limit for the Higher Income Child Benefit Charge (HICBC). There may also be an impact on capital gains tax - where a taxpayer’s income moves into higher rates, a corresponding higher rate of capital gains tax may become payable on any chargeable disposals arising.
Practical Tip:
A taxpayer who finds himself moving into the higher rate income tax bracket as a result of the restrictions may be able to reduce their taxable income, for example by carrying back pension contributions or Gift Aid donations from the next year.
