Currently landlords can claim tax relief on their mortgage interest payments, basically offsetting the cost of the mortgage interest from their rental income when calculating profits.
Here’s a simplified example of how tax is calculated on rental income:
Mrs Smith has a rental property, which gives her a rental income of £15,000 and pays £10,000 on mortgage interest. Therefore, her profits are the difference between the two, which is £5,000.
The tax landlords pay on their profits depends on their income tax band, so those on the basic tax band of 20%, pay 20% tax on their rental profits, whilst higher-rate tax payers pay either 40% or 45%.
As Mrs Smith is a higher-rate tax payer she will pay 40% tax on her £5,000 profit, which is £2,000. Leaving her with £3,000 profit.
From April, mortgage tax relief will gradually be cut back, over a three-year period, to 20%.
Once the new system is introduced, Mrs Smith will have to pay 40% tax on the full £15,000 less a 20% tax credit on the £10,000 mortgage interest (£2,000).
Mrs Smith’s tax bill will therefore work out at £6,000 minus £2,000 (tax credit on mortgage interest), which equals £4,000.
Under the new system Mrs Smith will make a final profit of £1,000, £2,000 less than previously.
The example highlights just how significant the changes will be, particularly for those landlords who pay the higher tax rates. There is also the potential that the changes could push those who pay the basic rate of tax, into a higher-rate tax bracket.
The changes highlight the importance of maximising tax relief for all allowable expenses relating to rental properties and reinforce the need to review your income, asset and tax position to ensure landlords maximise their net rental return.
There is also the option for landlords to change the ownership of their properties by setting up a limited company and transferring ownership, as a way of limiting their tax bill. Before pursuing this option, it’s important that landlords take into consideration the capital gains and stamp duty implications a transfer of ownership would entail, to ensure they don’t actually end up paying more tax!
The changes are likely to have a significant impact on the buy to let market and, potentially, an increase in rental prices as demand exceed supply. However, it’s important that landlords consider all the options prior to deciding whether to sell their properties. Despite the recent bad press, there are still options available to maximise the profit potential of their property portfolio, but landlords should seek professional advice prior to making any decisions or changes.