RESTRICTIONS ON INTEREST FOR BUY TO LET LANDLORDS

In this article I am looking at the changes made to the way interest is being treated for buy to let landlords. This is specifically relevant to those buy to let landlords who have highly leveraged portfolios of housing stock.

After reading this you will understand how the restrictions being placed on interest relief can have a massive impact on the viability of your but to let operation. In extreme cases the amount of tax being paid to HMRC could be larger than the money you are generating from property rentals.

The basics

With effect from 6th April 2017 tax relief on interest relating to residential property will be restricted and will only be given as a 20% income tax deduction. This is being phased into the tax system so that it will not be fully in force until the 2020/21 tax year. What a lot of people have not appreciated is that not only will interest only be given as a 20% deduction but it is also being disallowed in the calculation of profits.

This can massively increase an individual’s profits to the point where the amount you are paying in tax outstrips the amount you are earning from property income!

I will now show you two examples to explain this. The first is a simple situation where the landlord may just want to pay the extra tax but the second is an example where the landlord could be forced into a desperate situation and could face ruin without the proper business planning.

Example one: Individual with one residential rental property

In this example I will take a simple situation where one person rents out one property to supplement their income I will also assume that they are a higher rate tax payer which means they already pay tax at 40%. Looking at the table below you can see that in the 2016/17 tax year this person made ￡5,000 from renting out their property and paid tax of ￡2,000 giving them an income after tax of ￡3,000.

Once the interest rate restrictions are in full force in 2020/21 then interest is no longer allowed when calculating profits and it means that in this example taxable profits have been increased by ￡3,000. However, after the 20% interest relief there is only a small increase in tax of ￡600 and a profit after tax of ￡2,400. Overall then, in this situation the person may just want to suffer the additional tax. Note however how the cash after tax is not calculated using the ￡8,000 this is because the individual still needs to pay the mortgage interest even if they are not getting the tax deduction for it! We will see the true devastating effect of this in example 2.

Example 1:

                                    2016/17           2020/21

                                     ￡                 ￡

Gross rent received                      10,000             10,000

Less allowable expenses                  2,000              2,000

Less interest on mortgage                 3,000             (Not allowed) 

Net rental profit for tax purposes        5,000               8,000

taxed at 40% as higher rate payer         2,000              3,200

Less 20% interest relief                                      600

Tax liability                             2,000               2,600

Example 2: The buy to let landlord facing ruin

In Example two we have a buy to let investor who has a large property portfolio of fifty to sixty plus properties and they have built up this property empire by leveraging their existing property assets. The main point to note is that for this buy to let investor they have gone from a comfortable cash take home after tax of ￡40,800 where they are probably taking several holidays a year, driving a nice car and living in a nice house to a massive cash loss of ￡46,100 after tax where they will be struggling to put food on the table and to be honest would need to take drastic action or face ruin.

So how has this happened? As you can see from the below table, when interest is no longer allowed as a tax deductible expense this person’s profit shoots up from ￡50k to ￡400k. The main tax implication of this is that it puts them firmly in the additional rate tax band and they even lose their personal allowance. Faced with a tax bill of ￡96,100 is bad enough but remember they are still making the same ￡50,000 of cash leading to a massive cash loss.

Example 2:

                                  2016/17             2020/21

                                    ￡                    ￡

Gross rent received                     650,000              650,000

Less allowable expenses                 250,000             250,000

Less interest on mortgage                350,000              (Not allowed)

Net rental profit for tax purposes           50,000              400,000

Less personal allowance                  11,000 

Taxable income                        39,000              400,000

Tax @20%                             6,400                6,400

Tax @40%                             2,800             47,200

Tax @45%                                               112,500 

Less 20% interest relief                                      70,000

Total Tax liability                          9,200                  96,100

Cash profit/(loss) after tax             40,800                (46,100).

In this situation this person needs to take action. At Woods Russell we have already advised our clients on this situation and given them advice on how to mitigate its circumstances. If this situation is going to effect you I would strongly recommend taking professional advice from your accountant or tax adviser.