UK residential landlords – significant tax changes may lie ahead

The Government has passed legislation which will increase UK tax bills for most individuals (whether UK resident for tax purposes or not) owning UK residential let property, where the property has been part financed through mortgage debt. The changes take effect from 6 April 2017. Those with high gearing and significant interest payments will be particularly affected.

The changes come on top of an alteration to wear and tear allowance for landlords of furnished residential lets, coming into effect in April 2016, but in this briefing note, we focus on residential landlords with mortgages.

The current position

At the moment, if an individual takes out a loan to purchase UK residential property for letting, broadly he can deduct all the interest he pays to service the loan from the gross rental income. There is no upper limit on the amount of interest that can be deducted but the loan must be incurred wholly and exclusively for the purposes of the rental business. UK Income Tax is paid on the net rental income only.

The rules from 6 April 2017

Under the new rules, interest payments on mortgages and other financing costs cannot be deducted from the gross rental income. Income Tax will be paid on the gross rental income (assuming there are no other allowable expenses to be deducted, of course). Once the tax has been ascertained, a new relief – a tax deduction – will be allowed. The amount of the tax deduction will be basic rate relief (currently 20%) calculated with reference to the total interest payments and financing costs that tax year – at least, this will be the position from April 2020 when the new rules are fully phased in. In tax year 2017/2018, the new rules will apply to 25% of the interest payments, then 50% in 2018/2019 and 75% in 2019/2020, before applying to all interest payments in tax year 2020/2021.

The tax deduction operates as a tax credit, therefore, but it results in a much less generous tax treatment, as this basic example illustrates:

Assume a higher rate individual taxpayer owns a number of rental properties, in total generating £100,000 of rental income per annum. He pays £60,000 of mortgage interest per annum.

 
How will this affect you?

The changes affect individuals, trusts and partnerships (but not corporates, or corporates in partnership with an individual, unless the corporate is acting as a nominee for an individual or a trustee). The extent to which these landlords will be affected will depend upon factors such as their other taxable income and the rate at which they pay UK tax (basic, higher or additional rate), the extent to which the property is geared and the interest rate applicable to the loan.

Landlords will be concerned to understand whether the tax changes erode their net profit to such an extent that the letting is no longer profitable. To help you do this, we suggest that you take the last two or three years’ letting accounts and your UK tax returns and re-run the figures using the new rules (and this is something that our tax team can help you with of course).

Planning ideas

If you do not like how the new tax rules will affect you, what can you do? Here are some thoughts to consider:

The new rules do not apply to:

• commercial let property; or
• furnished holiday lets.

Is it viable to alter your property, or alter how it is let, so that it fits into one of these categories instead?

The new rules do not apply to property businesses carried on by a company. Should you incorporate your residential letting business? (Or can you go into partnership with a company of yours?) This is not a straightforward question to answer from a tax perspective:

• Transferring the property to a company could trigger UK Capital Gains Tax, if it is standing at a gain relative to its purchase price. Incorporation relief may be available to neutralise the gain but of course conditions apply.
• Transferring is likely to trigger UK Stamp Duty Land Tax, even if the transfer occurs for nil consideration.
• The company will have compliance costs associated with the annual filing of the Annual Tax on Enveloped Dwellings (ATED) tax returns, to claim the relief from ATED that the company should qualify for if the letting is to a third party unconnected with the company.
• Companies can still deduct unlimited amounts of interest payments from their rental income, and only pay Corporation Tax on that net rental income at 20%, falling to 18% by 2020. However, extracting profit from a company in the form of dividends will give rise to a further Income Tax charge in the hands of the recipients. The 2015 Summer Budget also heralded much less generous taxation of dividends from April 2016, with individuals receiving a measly £5,000 Income Tax credit against dividend income in future. Taxpayers needing access to all the rental income will have to do their maths very carefully before choosing to transfer to corporate ownership.
• If the let property is not a long-term hold, bear in mind that liquidating a company involves two layers of tax on gains. The company will currently pay 20% Corporation Tax on gains crystallised by it when it disposes of its assets on a liquidation. In addition, UK resident shareholders pay between 18% and 28% on gains realised when their shares are exchanged for sale proceeds following the liquidation of the company.

Fortunately there is still plenty of time to identify the right strategy and carry out any necessary reorganisation before 6 April 2017, but it is possible that the tax changes will have an impact on the market for residential lets if enough landlords decide that the figures no longer add up.