Residential Property Income Tax Changes
Individuals who let residential property face a number of changes to their tax position in the next few years.
Currently, letting residential property (even by individuals) is treated as a ‘property business’ for the purposes of calculating the taxable profit. Therefore, using normal business tax rules, interest paid on a loan to finance the purchase of a property which is subsequently let can be deducted 100% from the rental income received within the property business. For individuals who are landlords, the Government has decided to change this longstanding rule. In future, instead of deducting the interest from the letting profit before that profit is taxed, the individual will only be allowed an income tax deduction at the basic rate (20%) on the interest paid.
This is a major change for landlords, & the Government has stated that it does not wish to cause substantial short term disruption to the private rentals market. Therefore, the change will be phased in from the 2017/18 tax year, with transitional rules until 2020/21.
During the transitional years, the amount of the tax deduction from rents will reduce and the proportion of loan interest that will only qualify for basic rate tax relief will increase. In these transitional year’s landlords will be able to claim the following relief:
* 2017/18 - 75% of the interest against rents, 25% basic rate tax relief
* 2018/19 - 50% of the interest against rents, 50% basic rate tax relief
* 2019/20 - 25% of the interest against rents, 75% basic rate tax relief
However, any unrelieved interest can be carried forward to future tax years. HMRC have confirmed that the changes will have no effect where a property meets all the criteria to be a furnished holiday let.
What Are the Implications?
The change will likely affect higher & additional rate taxpayers who let out highly geared residential properties. Additionally, there are currently no proposals to change the eligibility criteria for tax relief on letting related borrowing. For example, it should still be possible to release equity on a buy to-let property by increasing the mortgage secured on it & still claim relief for all of the interest (albeit eventually only at the basic rate tax relief of 20%).
Individuals who currently pay tax at 40% or 45% on letting profits will pay more tax as a result of this change, although the increases planned for personal allowances & the basic rate band up to 2020 will help to mitigate the impact slightly. Landlords will need to consider these tax changes carefully when setting rent levels in future.
What Options Are Available to Mitigate the Tax Changes?
Ownership through a limited company could be a favourable option for some as the changes will have no direct impact on those who own & let residential properties through this method. Companies will continue to deduct loan interest as a business expense & get effective tax relief at up to 20% (although this will fall in future as the rate of corporation tax falls). However, by 2020, this change will remove the interest relief disincentive to holding buy-to-let properties through a company. Similarly, the ability to take income flexibly in the form of dividends will be more attractive to landlords who might otherwise lose their personal allowance. Of course, the effective rate of tax on dividend income has changed from 6 April 2016. Those taking low levels of dividends may suffer a lower effective rate because of the new £5,000 allowance, but those taking higher dividends may pay more as the rate of tax on dividends rises.
As there are many issues to consider, deciding on the most tax efficient way to hold buy-to-let properties is not straightforward. The best option will depend on individual circumstances & long term objectives. Incorporation of an existing property letting business may not be practicable in many cases, including where this would result in a large stamp duty land tax liability.
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