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The general press is awash with articles about how the new tax regime restricting interest relief will affect buy-to-let (BTL) landlords over the next few years – and what landlords should be doing about it. But these articles are not always accurate, or correct; some of the advice indicates a fundamental lack of understanding about how the new tax regime works.
Example 1: Mortgaging own home
There was an article in a well-known broadsheet newspaper towards the end of March this year, recommending that BTL landlords should consider extending the mortgage on their own homes in order to pay down their BTL mortgage debts, which are exposed to the new mortgage interest restriction, to just basic rate tax relief, being phased in over the four tax years 2017/18 through to 2020/21 (note that the new regime applies only for income tax purposes; this article looks only at individuals, etc., who pay income tax on their profits from residential property lettings).
The rationale appeared to be:
‘This would only work if the interest rate on your main mortgage is substantially lower than the rate you would have paid on the BTL mortgage. That’s because, while you would have had some interest tax relief on your BTL mortgage, (especially in the earlier years), you get none whatever on mortgage interest relating to your main home’.
The first point may or may not be valid; the second is dross in my view.
The point that borrowing against your own home to replace BTL borrowings works only when the interest rate on the former is relatively low because there’s no tax relief on borrowing against the main home, is simply incorrect.
There are two reasons why, as we shall see next.
1. You CAN get tax relief when borrowing against your own home anyway
It doesn’t matter what you borrow against but what you borrow for that determines tax relief. The collateral is not important, but the purpose is. You can, therefore, borrow against your BTL properties themselves, against your own home, or against a work of art, so long as you are borrowing to finance your BTL business. This would apply to financing or re-financing the BTL business.
HMRC’s Business Income manual confirms that the security for funds is irrelevant at BIM45685 (and that this applies specifically to income tax on property businesses).
2. But borrowing against your own home will STILL suffer the tax relief restriction
Unfortunately, the definition of loans that are caught for the new interest relief restriction (a ‘dwelling-related loan’ in the legislation at ITTOIA 2005, s 272B) is cast sufficiently wide that again, the source of the borrowing is basically irrelevant:
‘an amount borrowed for the purposes of the business as is referrable (on a just and reasonable apportionment) to so much of the business as is carried on for the purpose of generating income from land consisting of a dwelling-house’
Again, the source/security of the borrowings does not matter, but the business purpose does; interest (and other finance costs) on borrowing from a standard owner-occupier mortgage will be caught by the new restrictive regime, just as will standard BTL mortgages secured directly against the property portfolio.
Replacing expensive BTL borrowing with cheaper owner-occupier mortgage finance
If it is indeed the case that BTL borrowing is getting more expensive but owner-occupier mortgages are getting cheaper (and easier to obtain/extend), it makes perfect sense to replace expensive finance with a cheaper alternative – if you are in a position to extend your owner-occupier borrowings.
HMRC’s guidance at BIM45700 confirms:
‘A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction.’
It follows that the landlord can pay off expensive finance and take out cheaper finance (however secured), without tax implication – except that any subsequent restriction of tax relief on finance costs should be less because the finance cost itself has fallen.
Extending your borrowings is OK if you stay ‘in the black’
HMRC’s guidance at BIM45700 also confirms that you can withdraw money from your BTL business (for any purpose, including non-business), and get tax relief for any replacement borrowings then taken out, so long as your total borrowings do not exceed the capital introduced to the business, after adding profits made to date and deducting funds withdrawn so far. Amounts are adjusted in relation to losses, depreciation and other non-cash transactions.
Example 2: BIM45700 in action
Ronald buys a £200,000 BTL property with £50,000 from his pension pot and £150,000 mortgage.
He has introduced a £200,000 asset to his rental business, but the borrowing is only £150,000, so the capital that Ronald has introduced to the business is £50,000.
Let’s say that, three years later, he has made profits over the three years totalling £20,000 but withdrawn £30,000 from the business; his capital account has been reduced by £10,000 but is still £40,000 in credit. Ronald could, therefore, withdraw up to £40,000 for ANY purpose, and the interest would still be allowable.
While the borrowing would still be subject to the new restrictive regime, it would nevertheless remain eligible for relief at the basic rate of 20%, at least. BIM45700 confirms that, however the money is actually used, the borrowings are deemed to finance the property business and therefore have a business purpose – so long as the business remains ‘in the black’.
New cash basis rules for property businesses
The new cash basis rules in relation to property businesses will work slightly differently, in that they look only at the value of property business loans during the year and compare them to the market value of the property (or properties) when first let, plus any enhancements; there are no adjustments to reflect amounts withdrawn from the business, or profits made to date, etc. Relief will be permitted – subject to the new interest restriction – so long as borrowings do not exceed the value of the property when first let, together with any property enhancements. Where the aggregate loan value is excessive, finance costs will be restricted.
While this may look similar to the original rule in the previous section, note that there are no adjustments for profits or drawings made to date since the business began. The new cash basis is potentially useful to those landlords whose drawings are such that they would not get full tax relief under the original rules. However, the new cash basis has been excluded from the much-abridged Finance Act 2017 that was rushed through ahead of the general election – although it may well be re-instated following the election.
Whilst I think it is generally helpful that mainstream media outlets are publicising the new interest restriction regime, some articles are less helpful than others – there is no substitute for tailored professional advice. Given the negative publicity, it is perhaps important also to emphasise that there should still be some tax relief on mortgage interest for residential lettings, even if it is restricted to just 20%. It will still be advantageous to arrange finance so as to get at least some tax benefit – although this does, of course, have to be weighed against borrowing costs themselves.