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• HM Revenue & Customs guidance (BIM45700) - Allowable interest on capital withdrawal.
• Use against a main residence mortgage.
• Examples and problems.
This month Mark Carney, as the new Bank of England governor, announced his plan for the country’s journey back to financial stability. His policy is to keep interest rates low until certain economic conditions are met. In spite of this, the rates at which banks lend to one another have been steadily rising in recent weeks; inter-bank lending being a key indicator of the future direction of fixed rate mortgages. Interest rates have been low for a long time now, and banks are thinking that rates must rise sooner than Mr Carney thinks. In addition, according to the Council of Mortgage Lenders, remortgage lending now accounts for 28% of all mortgages which suggests that many borrowers are remortgaging to protect themselves against impending rate rises.
Property Tax Insider is not a publication that can advise on whether you should remortgage and fix any property portfolio mortgage. However, what we can do is remind readers that if you have equity available in your property portfolio and are considering remortgaging, in your calculations you remember to take into account the additional value of paragraph BIM45700 of HMRC’s Business Income manual: www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htm
Reminder: BIM 45700
BIM45700 has as its heading “Specific deductions - interest: Withdrawal of capital from a business”. The section not only relates to property mortgage interest, but to any business where the owner has capital in a business and wishes to withdraw some of that capital. Instead of selling the asset, if he withdraws the capital via use of a loan then the interest paid on the loan is allowable in full against the profit made. This is possible because the original reason for the loan remains; namely to fund the capital in the business. HMRC’s guidance actually states: “Proprietors of businesses are entitled to withdraw their capital from the business, even though substitute funding then has to be provided by interest bearing loans. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business.”
Renting out any property is generally deemed a ‘business’ and as such the ‘capital’ investment placed into a rental business is the property itself. Should the owner wish to withdraw some of that capital at a later date, he can do so via the means of remortgage rather than having to sell the actual property. The loan is a qualifying loan and the interest paid is tax deductible in full. There is nothing in the tax rules to restrict the purpose of the loan, and the money can therefore be used for whatever purpose.
Use against a main residence mortgage
As most property investors are aware, interest relief is not available on interest paid to purchase their main residence. A landlords’ main residence does not form part of a property portfolio; no rental income is received so no interest relief is possible. However, rent out another property and there is your property portfolio; the capital in the business being the rental property itself. Remortgage that property and that releases some capital amount which can be used for whatever purpose, including reducing the main residence mortgage.
However, there is one restriction, which is that the amount of equity/capital that is released via the remortgage must not be greater than the market value of the propertywhen it was originally let. If the property had originally been bought for the purpose of letting, then the maximum amount would be the purchase cost of the property. If the loan is on property which had been purchased as a main residence and then been let at a later date, then on remortgage the amount of tax relief is restricted to the value of the former main residence on the first day that the property becomes tenanted.
Example 1- The ‘usual’ scenario
In June 2000, Jane borrowed £80,000 to purchase a £100,000 buy-to-let property, which was let immediately. Jane lives elsewhere as her main residence. It is now June 2013, and the property is worth £150,000. The allowable amount of mortgage overall will therefore be for £100,000; interest relief will be possible on the extra £20,000 borrowing and this amount can be used to reduce the mortgage on the main residence which does not qualify for interest relief. If the interest rate on the rented property is 4.50% and it is 5% on the main residence, it makes financial sense to use the remortgage amount to repay some of the higher interest mortgage by borrowing at effectively 3.60% after tax relief, rather than 5%.
The reason why the interest relief is allowable is not because the property in the rental business has a mortgage on it, but because the proprietor in the business has a capital account already in the business that can be withdrawn. To withdraw, the business must find an alternative funding source, making the borrowing for the purpose of the business.
Example 2 - Further points to consider
Jane has paid off the mortgage on her main residence (property 1), which is currently valued at £180,000. She wishes to move to a bigger main residence (property 2), valued at £230,000. She has £55,000 to pay as a deposit on the main residence but will need to raise the balance of £175,000 via a mortgage. She intends to rent out property 1. Which is the best scenario for the maximum tax relief to be achieved on interest paid?
Problem 1 - Until Jane has moved from property 1 and commenced renting, technically there is no business. When the property is subsequently rented then there will be a business and capital available to withdraw, for which alternative loan funding will be required. There is no need for any funds to go into the letting business but there does need to be a business in place. However, technically a business can commence the day you start looking for a tenant, so this could be before actually moving.
Problem 2 - Deciding against which property to place the mortgage. Interest rates on ‘Buy to let’ are currently lower than for residential property, but more equity is required (currently an average of 4.60% for a 70% mortgage which, with tax relief, will reduce the interest to 3.68%). Interest rates on a main residence average 5.20% for a 65% mortgage. On purely these percentages it would be better to mortgage property 1 to the maximum 70% and then obtain a mortgage on property 2 for the balance of £49,000 (not forgetting to place the £55,000 cash deposit against property no 2 as well).
Problem 3 - The property should pay for itself. The rental income received will need to more than cover the interest payments net of tax relief plus any additional costs such as letting agent fees, general repairs and property refurbishment etc, plus, remember the risk of defaulting tenants and void periods. The amount gained by placing the maximum mortgage against property 1 (i.e. 1.52%; being 5.20% - 3.68%) might not make renting worthwhile in comparison with selling. If the rental income does not make renting pay, losses will result and could remain unused as they cannot normally be offset against any tax paid on other income, only on profits from the rental income. This might not be a problem if there is more than one property in the portfolio.
Problem 4 - Take into account any capital gains on final sale.
• Savings interest is currently less than 1%; therefore its best use would be to reduce the higher mortgage.
• A ‘principal private residence’ election is required within 2 years of purchase of the second property.
Practical Tip :
HMRC must be informed of a new source of income by 5th October following the end of the tax year.
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