So, the Chancellor has decided to change the way income tax is calculated for private landlords and there are no prizes for guessing that it’s not good news for many. His changes are being phased in from April 2017 and will be implemented in full from April 2020.
The principal change is that mortgage interest relief is no longer allowable as an expense before calculating your (taxable) profit and, instead, an allowance is made against your tax bill. The official guidance is on the government website but here’s a simple example to explain how it works. Obviously each landlord’s tax position will be different so the following explains the principles only; you will need to take advice from your accountant on your personal situation. With that caveat ringing in the air, let’s leap into a simple example:
Consider a property that currently earns £10,000 rental income. Lets assume that the expenses such as agents fees and maintenance are £2,000 and mortgage interest £5,000. Under pre-April ’17 rules the landlord could deduct £7,000 of expenses from the gross income, leaving a taxable profit of £3,000 to be declared on their tax return. This would result in a tax bill of £600 for a basic rate tax payer or £1,200 for someone paying 40% income tax. Straightforward enough.
Jump forward to April 2020, assuming income and expenses have stayed the same over the intervening 4 years, the tax will work like this:
The landlord can claim the fees against the property income as before, but not the mortgage income, giving them a taxable income of £8,000 (£10,000-£2,000). So at basic rate they’d pay 20%, or £1,600, and at 40% they’d pay £3,200 in tax. Against this tax bill they can then claim a basic rate allowance for finance interest costs, i.e. 20% of the interest cost of £5,000, or £1,000. The allowance is the same whether you pay basic or higher rate tax, meaning a basic rate tax payer will now pay £600 (£1,600-£1,000) and a high rate tax payer will pay £2,200 (£3,200-£1,000).
As the Chancellor intended, the changes have the biggest impact on high rate tax payers but there are now situations where theoretically a highly geared 40% tax payer could end up being liable for more income tax than the ‘profit’ the property generates.
The second implication is that, in our example, a basic rate taxpayer’s income has apparently increased from £3,000 to £8,000 which could potentially have a knock-on effect to things like child benefit, if it takes joint income over the benefit threshold.
Just further complicate matters, the changes are being phased in over the next 3 years, so in 2017/18 you will be able to claim 75% of the finance costs as a property expense and reclaim 25% of the tax rebate, in 2018/19 you’ll be able to claim 50% of each and in 2019/20 it’s 25% and 75% respectively, before the full introduction from 2020/21.
The message is that you really do need the advice of a professional accountant to determine the most tax efficient way to hold and manage your portfolio.