From April 2017, the way in which tax relief on mortgage interest is calculated is going to alter.
Up until now, you have been able to offset your mortgage interest, as an allowable expense, against the income you earn on the property investment. In fact, most accounting standards and countries around the world adhere to this simple premise. As a property investor, you’ll owe tax on the entire rental income less the allowable expenses.
You’ll still be able to claim tax relief on your mortgage interest, but the rate at which that relief is given will be gradually reduced until it is given at 20% (the basic rate of income tax) in 2020/21.
Instead of deducting the mortgage interest paid from the rental income, you’ll have two calculations to make:
- Calculate your tax on the gross rental income (after tax allowable deductions have been made)
- Calculate the tax relief on the mortgage interest at the basic rate of tax
So, let’s see what difference this change makes to our two investors above:
Example – Assume the Investor has a property whose Net Rent is £1000 per month and mortgage payments are £600 per month on a £240,000 mortgage owing.
The basic rate tax payer:
- Tax on gross rental income = 20% x £12,000 = £2,400
- Tax relief on mortgage interest = 20% x £7,200 = £1,440
- Tax under old scheme = £960
- Tax under new scheme = £960
- Difference is zero
One point is to be careful as the non deduction of the mortgage interest may tip you over the basic rate into the additional rate of tax.
The higher rate taxpayer:
- Tax on gross rental income = 40% x £12,000 = £4,800
- Tax relief on mortgage interest = 20% x £7,200 = £1,440
- The tax under old scheme = £960
- Tax under new scheme = £3360
- Difference is £2400
As you can see, if you’re a higher rate taxpayer and have invested with the help of a mortgage, the effect of this tax change is that your tax bill will go up by £2400 per year. That’s just the start because the question is where do you find that extra money from?
Now for the real kicker… What happens if interest rates you’re your mortgage payments to increase, the effect could be catastrophic.
What happens if interest rates rise?
Let’s stick with the same example, and let’s imagine that both property investors are currently paying mortgage interest at 3% on their buy-to-let mortgages. Now let’s imagine that the Bank of England raises the base rate, and lenders respond by raising rates on their buy-to-let mortgages to 4.5%. Look at what happens to the positions of the two property investors in our example:
The basic rate taxpayer:
- Tax on gross rental income = 20% x £12,000 = £2,400
- Tax relief on mortgage interest = 20% x (£240,000 * 4.5%) £10,800 = £2,160
- The tax under old scheme = £960
- Tax under new scheme = £960
- Notice the tax stays the same as interest rates rise and fall.
- The difference is that you are now paying an extra (£10,800 – £7200) £3600 per year on your mortgage.
The higher rate tax payer:
- Tax on gross rental income = 40% x £12,000 = £4,800
- Tax relief on mortgage interest = 20% x £10,800 = £2,160
- Tax under old scheme = £960
- Tax under new scheme = £3360
- Difference due to additional Interest payments £3600 + Additional Tax £2400 = £6000 per year.
- In addition, the property is now making a cash flow loss each year of £1440. So you are paying tax even though you are making a loss.
That’s a full £6000 per year you have to find. Stolen from you.
As you can see, the higher rate taxpayer is now making a loss because of the changes in the way that mortgage interest relief is calculated and the increase in the mortgage interest rate.
I cannot stress enough how important it is to be aware of this effect.
Plan now for this UK Property Tax change, because you still have time to take action that will ensure your property portfolio remains profitable, and if not profitable at least viable.
Live with passion and fun,
Brett Alegre-Wood
