In April 2016, the Additional Dwelling Supplement (ADS) was introduced for those purchasing a second property. While ADS affects people in a number of different scenarios, the main impact has been on small scale landlords.
Prior to the introduction of ADS, changes in the way pensions could be withdrawn opened up opportunities for those approaching retirement to invest in one or more buy-to-let properties, securing an income for their later life. ADS reduced the appeal of this option somewhat, as any purchase of a second property over £40,000 now incurs a further 3% tax on the purchase price.
This month small landlords who are higher rate tax payers have been handed another financial hurdle, as the amount of tax relief that available on will be reduced to match those available to basic rate tax payers.
Many small landlords finance property purchases through interest-only buy-to-let mortgages. Under previous rules, a landlord would pay income tax on the net profits of their rental at their personal rate of income tax - basic rate 20%, higher rate 40% or additional rate 45%. Interest payments made to a mortgage were an allowable deduction before the amount of tax payable was calculated.
Going forward however, mortgage interest will not be deductible – instead a tax credit equal to 20% of the interest paid to the mortgage will be available. This new rule will be phased in over the next three tax years taking full effect in April 2020.
• In 2017/18 75% of costs will be available for relief prior to tax being calculated, with the remaining 25% eligible for a basic rate tax credit of 20%;
• In 2018/19, this reduces to 50% available for relief, with 50% eligible for a basic rate tax credit;
• In 2019/20 25% will be available for relief, with 75% eligible for a basic rate tax credit; and
• From April 2020, 100% of financial costs will only be eligible for a basic rate tax credit.
Let’s look at how the changes may affect you.
Old Rules (2016) New Rules (2020)
Rental Income £10,000 Rental Income £10,000
Mortgage Interest £4,000 20% tax credit
Profit £6,000 on mortgage interest of £4,000 £800
Income Tax at 40% £2,400 Net Profit £9,200
Income Tax at 40% £3680
Whilst those landlords who pay basic rate tax will not be directly affected by this change, the alteration in the way profit are calculated could easily push them into the higher tax bracket.
As limited companies will not be affected by this change, some landlords are looking to set up a company to ease their exposure to the new tax rule. However this can come with its own issues, as a transfer of title is considered a sale by HMRC and may, therefore, attract Capital Gains Tax.
With so many aspects to consider when looking at buy-to-let as an investment option, it’s worth taking professional advice early on in the process to ensure you are not paying more than is required down the line.
Stephanie Pratt is an associate in our Private Client team. With extensive experience in setting up trusts and tax planning, she helps clients manage their affairs efficiently and cost effectively.