Tax on rented property: the income tax implications of B2L property ownership
General position – tax on rented property
If you directly invest in UK B2L property then you will be subject to income tax on net rental income from your buy to let properties at your marginal rate of income tax. Essentially, this will result in you paying the following tax on rented property:
- 20% tax to extent the net profits fall in the basic rate band;
- 40% tax to the extent the net profits fall in the higher rate band; and
- 45% tax to the extent the net profits fall in the additional rate band
As such, deductions from the gross rental income are important in reducing the amount of taxable income and the overall tax on rented property.
Though by no means an exhaustive list, some of the main relevant deductions where calculating the tax on rented property will generally be as follows:
- Insurance costs
- Advertising the property
- Redecorating the property
- Maintaining the grounds and gardens
- Professional fees – such as accountancy expenses
- The legal costs in removing an errant tenant
- Travel expenses – for instance, visiting properties in the portfolio
- Finance costs – this will include interest on borrowing and, for many investors, will be one of the biggest deductions. Unless you’ve been living under a stone you will be aware that for certain types of property investor – including individual residential property investors – April 2017 introduced a phasing out of the deduction for part of the interest deduction (see below)
It should be noted that for any costs to be deductible then they must:
- be of a ‘revenue’ nature (ie not capital); and
- must be incurred wholly and exclusively for the purposes of the business.
The first of these in relation to, say, redecorating the property might mean that repainting the walls between tenants would be deductible in determining the tax on rented property. However, building a new extension would not be. In the first example, the costs would be offset against the gross profits of the business. However, in the second, this expenditure would be taken in to account for capital gains purposes on a future sale.
Finance costs and loan interest relief – general position
As mentioned above, there have been some significant changes to the deductibility of loan interest, and other finance costs, which apply from April 2017. These are so significant that, where an individual has a highly geared portfolio, the additional tax on rented property might well mean that the economics of maintaining the portfolio be turned on its head.
One of the main tax deductions will be your tax deduction for interest.
Traditionally, all the tax legislation has required that, like any other genuine cost of operating your (property) business that any loan interest is incurred ‘wholly & exclusively’ for the purposes of the business. Where this is the case it will act to reduce the tax on rented property.
Alfred purchases a B2L property with a mortgage. He lets the property. The interest on the mortgage is allowable as a tax deduction against the profits.
Belinda owns a mortgage free property. She decides to take out a loan secured on the property to facilitate some extensive improvements as it has become tired and unappealing. As in the first scenario, the loan interest is deductible and will reduce the tax liability on the rent.
One interesting point is that the source of those funds is irrelevant. HMRC publishes its ‘internal’ manuals online and states that:
‘The security for borrowed funds does not determine the use of those funds.’
Of course, this makes perfect sense.
As anyone who has started a business and needed to try and secure funding from the bank will tell you it is likely the lender will try and obtain security over the business owners home or other assets. However, this does not mean that the interest on the loan, which is paid by the business, is not deductible by the business.
The same applies in the context of a property business. A loan could be secured on your main residence, but the interest relief could still be claimed by the business.
Subject to the particular circumstances, it might also possible for the business to secure funding on existing property and the proprietor to withdraw these funds as capital from the business. The borrowing would still qualify for interest relief.
The law of diminishing returns? Loan interest relief from April 2017
With effect from 6 April 2017, certain property investors will no longer be able to deduct their full finance costs from the gross rental income when calculating their tax liability.
The rules are focussed narrowly at residential property investors and those investors that are subject to income tax. As such, this will include individuals acting as landlords plus Trustees, partnerships and LLPs.
This restriction in loan interest relief will be gradually phased in from 6 April 2017.
It seeks to apply a two-step process when calculating an affected person’s tax liability:
- STEP ONE: when taking the rental profits from the accounts one should add back the loan interest (and other finance costs) paid. The tax liability is then calculated after this loan interest is added back.
- STEP TWO: Once the tax liability has been calculated, then a tax credit of 20% x loan interest is allowed as a deduction at the bottom of the tax comp.
The effect of STEP ONE is clearly to create phantom profits.
The effect of this steps is gradually phased in over 4 years. In the first year (2017/18) 25% of the interest cost is added back in this way with the corresponding tax credit applied with the remainder taxable as before. Each year, a further 25% will go through the two-step process described above, with the balance being treated in the traditional fashion until all interest relief will follow the same two step dance.
These changes, where borrowings exist on the portfolio, will clearly increase the tax on rented property.
As stated above, the rules only apply to income taxpayers. As such, UK companies are not caught by the amendments. A non-UK company would also be subject to income tax on this type of profit under the non-resident landlord scheme. However, such companies are explicitly excluded from the new provisions.
In addition, there are also some other key exclusions:
- Any finance costs taken out in order to undertake a property development are ignored, even if secured on a let property;
- Furnished Holiday Lettings (“FHLs”) are excluded from the new rules
It is worth noting that the loan interest rules will potentially have other consequences on impacted taxpayers. This is because it will have the effect of increasing taxable income. As such, this might negatively impact:
- Child Benefit – potentially creating a Child Benefit Tax charge;
- Result in a reduction in tax credits; and
- Restrict the amount of the personal allowance for a particular year
Jointly property – married couples and civil partners
Married couples often hold investments jointly.
This type of scenario lends itself to tax planning, and reducing tax on rented property, in circumstances where one spouse or civil partner is a higher rate taxpayer and the other is a basic rate taxpayer or has little income or no income at all.
There are perhaps two key ways of achieving this:
Once could adopt a straight bat approach to proceedings and transfer the desired legal and beneficial ownership to the other spouse or civil partner and, as such, putting the income in to their name.
Each spouse would receive income based on the split in ownership and would, of course, pay income accordingly applying their own personal allowances and basic rate bands where applicable.
In principle, this should not create any issues with HMRC. However, where such a transfer is fettered in any way then one must be careful of any applicable anti-avoidance rules.
The alternative would be to leave the property registered in their own names. However, a written declaration is made ‘splitting’ their interests, and entitlement to income, as desired.
HMRC provide a specific form for reporting such transactions.
Enterprise Tax Consultants can help with tax on rented property
We are helping property investors, both UK and non-resident, and buy to let owners review their tax planning to help identify all tax liabilities (SDLT, income tax etc) and potential reliefs while meeting their commercial goals in a responsible and personal manner.
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If you have any queries about tax on rented property or other tax related matters then please get in touch.