Understand income tax issues to maximise net rental profits
When you invest in property, you should give some consideration to how much tax you might pay on the rental income. Now, I have never believed that tax should be the reason not to invest. However, understanding the tax implications of owning and operating an investment property as a buy-to-let will help you decide how to structure your investment and reduce the tax liability.
In this article, you’ll learn how rental income on residential investment property is currently taxed (tax year 2018/19).
Tax relief on mortgage interest
Before we get started, we need to point out that the way financing costs are treated for tax is changing. The ability to deduct mortgage interest from your rental income before calculating your tax liability is being phased out. By 2022, instead of being able to offset your mortgage interest payments against your rental income, you will instead only be able to claim a tax reduction of 20% of the mortgage interest cost.
You can learn how this will impact you in our article “UK Property Tax: How mortgage interest tax relief is changing”.
What if you increase the mortgage on your investment property?
If you increase the mortgage on your investment property, for tax purposes you can treat the extra interest as you do the current interest you pay, providing the extra loan is used exclusively for your business. However, any interest on extra borrowing above the value of the property when you bought it is not tax deductible.
To keep things simple as an introduction to tax on rental profits, we’ll be looking at tax on rental income without the complication of a mortgage interest tax relief calculation – which, of course, may serve to further reduce the tax you pay.
What are allowable expenses?
You can deduct allowable expenses from your rental profit to reduce your tax liability. Even if you have no tax liability, you should do this. It’s good practice to do so and may result in losses that you can carry forward to offset against tax in later years.
Expenses must be incurred for the purpose of your rental business. They include outgoings such as:
- Landlord insurance
- Property management fees
- Legal expenses
Now, let’s look at a couple of examples to see how much tax you may have to pay.
The tax you’ll pay if you have no other earnings
Let’s say that you have no other income other than your rental income. Working out how much tax you will need to pay is relatively easy in this case. Here’s an example:
Step 1: Calculate rental profit
- You earn £15,000 in rental income
- Your allowable buy-to-let expenses are £2,500
- Your rental profits are therefore £12,500
Step 2: Deduct your personal tax allowance
Your personal tax allowance for this tax year (2018/19) is £11,850. You deduct this from your income, and this leaves the amount of income on which you will be liable to pay tax.
Your taxable income is £12,500 – £11,850 = £650
Step 3: Calculate your tax liability
The final step is to calculate the actual amount of income tax you should pay. The first £34,500 of taxable income is taxed at 20%, and so in this example, you would be liable to pay £130 income tax (£650 x 20%).
What if you have other income, too?
Now, let’s say that you also earned money from employment. Your employer would have deducted income tax through the Pay As You Earn system (PAYE). When completing your tax return (Self Assessment), you must show this on the employment page.
The tax you pay on your rental profits depends upon your total income. If you earn £18,000 from your job and £12,500 in rental profits, the calculation of your tax liability is as follows:
Step 1: Calculate total earnings
Earned income of £18,000
Plus rental profit of £12,500
Total income = £30,500
Step 2: Deduct your personal tax allowance
£30,500 – £11,850 = £18,650 of taxable income
Step 3: Calculate your total tax liability
Your total tax liability in this example is:
£18,650 x 20% = £3,730
Step 4: Calculate how much you will have to pay for your rental property profits
To calculate how much tax you will need to pay for your rental profits, you will need to deduct the tax already paid through PAYE from your total tax liability. In this example, your employer will have paid the following tax on your behalf:
- Earnings = £18,000
- Personal tax allowance = £11,850
- Taxable income from employment = £6,150
- Tax paid = £6,150 x 20% = £1,230
- Tax due = £3,730 – £1,230 = £2,500
If your rental profit takes you into a higher rate band of income tax, you will need to pay income tax at the higher rate on the proportion of your rental profit in the higher rate band.
What if you own more than one investment property?
If you own a portfolio of several buy-to-let properties, the income and expenses from all the properties are added together to calculate your overall rental profit before calculating your tax liability.
What if you make an overall loss?
There may be occasions when you make an overall loss. Perhaps you had a tough year when some of your properties required major repairs, sending your total rental profits into the red. In this case, you can carry forward the loss to offset against profits from the same property portfolio in the future.
What if you own property jointly with another?
If you own buy-to-let investment property with another person, your tax liability will be calculated using the proportion of rental profits decided by the share of the property you own. If you want to receive a different proportion of the profits to that decided by the proportions of ownership, you must let HMRC know by completing a declaration of beneficial interests in joint property and income (Form 17).
How should you structure your property investment?
Understanding how you might be taxed on buy-to-let investment property will help you decide how to invest. There are many structures that can be used to minimise tax liabilities and maximise net rental profits. Which is best for you depends on your personal circumstances.
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