UK investment property - time to put up the rent?

HMRC are introducing new rules which will restrict the amount of tax relief available to landlords for finance costs relating to residential properties.

These changes do not extend to furnished holiday accommodation.

You will only be affected by these changes if you have a loan on your investment property.

So, what are finance costs?

This includes loan interest, as well as incidentals costs of arranging and repaying the loan.
For individuals, the amount of tax relief will be restricted to the basic rate of income tax (20%). The restriction will be phased in over 4 years, commencing April 2017.

Currently, finance costs are deducted from rental income, together with any other allowable property expenses. Following the change, finance costs will not be included when calculating the net rental income. Instead, the income tax liability will be calculated (including other sources of income) and a reduction will be made with reference to the basic rate value of the finance costs.  

What if net rental income is less than the finance costs?

The tax reduction is not given against other sources of income. Excess finance costs can be carried forward against the calculation of the basic rate tax deduction in future years.
Confused? Let’s look at a couple of examples.

Example 1 - before and after the changes

                                 2016/17                                    2020/21

Employment income     £40,000                                               £40,000
Property income           £15,000                                               £15,000
Finance costs             (£10,000)                                             (£0)
Other expenses           (£3,000)                                               (£3,000)
Net rental income         £2,000                                                 £12,000

Taxable income           £42,000                                               £52,000

Tax calculation
£11,000 @ 0%                         0                      £11,000 @ 0%             0         
£31,000 @ 20%                       £6,200              £32,000 @ 20%            £6,400            
                                                                        £9,000 @ 40%            £3,600

                                                                        Tax reduction

                                                                        £10,000 x 20%     (£2,000)

Final tax                                  £6,200             Final tax                      £8,000

Example 2 – carry forward (finance costs of £10,000)

                                            2016/17                                      2020/21

Employment income               £40,000                                               £40,000
Property income                     £15,000                                               £17,000
Other expenses                     (£8,000)                                               (£3,000)
Net rental income*                  £7,000                                                 £14,000

Taxable income                      £47,000                                               £54,000

Tax calculation
£11,000 @ 0%                         0                      £11,000 @ 0%             0         
£32,000 @ 20%                       £6,400             £32,000 @ 20%           £6,400            
£4,000 @ 40%                         £1,600             £11,000 @ 40%           £4,400

Tax reduction*

£7,000 x 20%                     (£1,400)           £13,000 x 20%       (£2,600)

Final tax                                  £6,600             Final tax                      £8,200

*Finance costs restricted to £7,000 of £10,000, therefore £3,000 carried forward.

What are the transitional provisions? The change will be phased in from 2017/18 as follows:
Property income deduction phased out:
  • 75% of finance costs deductible from rental income in 2017/18
  • 50% of finance costs deductible from rental income in 2018/19
  • 25% of finance costs deductible from rental income in 2019/20
Basic rate tax deduction phased in and based on:
  • 25% of finance costs in 2017/18
  • 50% of finance costs in 2018/19
  • 75% of finance costs in 2019/20

Example 3 – 2017/18 (finance costs £10,000)

Deduction = 75%                                             Basic rate tax reduction = 25%

Employment income               £40,000           £11,000 @ 0%             0
Property income                     £15,000           £32,000 @ 20%           £6,200
Finance costs                       (£7,500)            £9,000 @ 40%             £600
Other expenses                    (£3,000)            Tax reduction                         
Net rental income                  £4,500              £2,500 @ 20%             £500   

Taxable income                      £44,500           Final tax                      £6,300
 

In conclusion.

There will be an impact in the reduction of tax relief for finance costs, resulting in more tax to pay. In addition, the disallowance of finance costs will increase taxable income, even for a basic rate taxpayer. Potentially there could be a further impact on a restriction to the personal allowance. Result – your tax liability will increase as a result of these changes.

What if I decide to sell the investment property before these changes take effect?

Speak to us beforehand to discuss the capital gains tax implications as a non-resident property owner, so you can quantify the potential tax liability and factor this in to your decision. If you are not already aware, HMRC introduced changes for non-resident capital gains tax from 5th April 2015.

For further information or assistance please contact:
Wendy Davies
Director, Tax and Business Advisory
E: wdavies@moorestephens.com.au
T: +61 (0)8 9225 5355.