Update 30 October 2024 – Following the Budget announcement today, some of the details mentioned in this insight may have changed. Please visit our Budget page for further information.
If you’re a residential landlord you need to be aware of the changes to the way tax on rental income is calculated – and how they could mean you pay tax on a higher amount than your actual profit.
Last year, George Osborne announced plans to restrict the amount of mortgage interest landlords can claim as a deduction from their rental profits. For many landlords, this means the eventual figure that tax is deducted from will be significantly higher. The change is set to be phased in from 2017 and will be in full effect by 2020. It is one of a raft of measures aimed at addressing the imbalance between buy-to-let investors and homebuyers struggling to get on the property ladder.
New calculation to lead to tax hikes for landlords
When renting out a residential property, you’ll need to pay tax and possibly National Insurance (NI), depending on your circumstances. Rental profits are taxed at the same rates as employment income, meaning basic rate taxpayers will pay 20% and higher rate taxpayers will pay 40%, with the additional rate set at 45%.
Rather than being able to deduct the entire cost of mortgage interest from your taxable income, your mortgage income tax relief will gradually be cut back to 20% by 2020.
Tax needs to be paid on the profit made from renting out the property, following deductions made for allowable expenses. These include anything necessary to aid the day-to-day running of the property, including:
- Letting agents’ fees
- Accountants’ fees
- Maintenance and repairs
- Utility bills
- Council tax
Interest on property loans is also on this list. However, its reduction to a rate of 20% means if you have a buy-to let mortgage you will be paying tax on a higher profit than you have actually made.
What are the specific tax implications for landlords?
It’s not simply a matter of paying more. Depending on the size of your mortgage, your mortgage rate and your annual rental income, you could feel the effects of the changes in a number of ways. Inevitably, without being able to deduct mortgage interest you’ll be taxed on a higher amount. This could see you bumped up into a higher tax band, which will be of particular concern if you’re a basic-rate taxpayer.
If you’re a higher rate taxpayer and your mortgage interest exceeds 75% of your rental income after expenses, it’s believed that all of your returns will be wiped out by 2020 when the changes are fully implemented.
For example, suppose you’re a higher rate taxpayer. Your annual rental income is £20,000 and you have to pay £15,000 in mortgage interest. You pay £8,000 tax on your £20,000 rental income which is charged at 40%.
From this, you deduct £3,000 (the 20% credit on the £15,000 mortgage interest) leaving you with an income tax bill of £5,000. Add this together with your mortgage interest for the year and you are having to pay out £20,000 in total, leaving you with an annual profit of zero.
How can I soften the blow?
Depending on the size of your property portfolio, you might want to consider incorporating your property business. The restrictions on declaring mortgage interest as a deduction of rental profits won’t apply to companies. Incorporating also means you’ll be taxed at the 20% corporation tax rate, regardless of the tax band you fall into.
Be warned though, there are other issues to consider. You’ll probably have to pay Capital Gains Tax (CGT) at a rate of 18%-28% when shifting a property into company ownership. You’ll also have to weigh up the combined costs of corporation tax and dividend tax. This is considered to be a more viable option for those who generate significant income from buy-to-let.
The upcoming changes are set to hit landlords hard. You need to make sure you’re completely in-the-know as to how much your income is going to be affected and whether there’s anything you can do to soften the blow. For more information and further advice, please contact our property and construction accountants. We’d be more than happy to help.
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