Property Income Tax: Changes from April 2016
The Summer Budget introduced new rules to limit tax relief on finance costs (FC) incurred by buy-to-let landlords. The main reason for this change is to make the system fairer for individuals who buy a home to live in and do not have the option to offset their mortgage interest against their taxable income as buy-to-let landlords currently do.
There are three key changes for landlords to be aware of:
- Gradual reduction of FC deductible from rental profits between 2017/18 and 2020/21. By 2020/21, the tax relief available to landlords for loan interest will be limited to basic rate on that interest;
- Abolishment of the 10% Wear & Tear Allowance from 6th April 2016;
- Increase of the level of tax relief under the “rent a room relief” scheme from £4,250 to £7,500 from 6th April 2016.
1 - Reduction of FC Relief
Under the current system, FC – e.g. mortgage interest, interest on loans for furnishings, professional fees on arranging/renewing loans and mortgages, etc. – are deductible in full from rental income.
Under the new rules, the full deduction of FC from rental profits will no longer be allowed. However, buy-to-let landlords will be able to use FC as a basic rate relief for their rental tax liability. The new rules will be gradually phased in from 6th April 2017 over the next four years. This change will affect higher rate and additional rate taxpayers.
- First phase (2017/18) – The deduction of property FC will be limited to 75%. The remaining 25% will be available for basic rate relief through a reduction in their rental liability;
- Second phase (2018/19) – The deduction of property FC will be limited to 50%. The remaining 50% will be available for basic rate relief through a reduction in their rental liability;
- Third phase (2019/20) – The deduction of property FC will be limited to 25%. The remaining 75% will be available for basic rate relief through a reduction in their rental liability;
- Final phase (2020/21) – FC will stop being deducted from the rental income and only a tax reduction at the basic rate of income will be available.
Whilst losses will be carried forward to following years in accordance with the current rules, the basic rate tax relief can be carried forward if the tax reduction for the year has been restricted to 20% of the property profits for the year.
The below example goes through all the four phases of the change and it assumes a higher rate taxpayer who has utilised his personal allowance for the year. This is how we believe the new rules to work although the draft legislation will be published later this year.
| First Phase (2017/18) | Tax Reduction to be C/F |
Losses to be C/F |
||
|---|---|---|---|---|
| Rental Income: | £5,000 | |||
| FC: | £ 3,000 @ 75% | (2,250) | £750 | |
| Other Expenses: | (6,000) | |||
| Taxable Profit/(Loss): | (3,250) | £3,250 | ||
| £750 | £3,250 |
In the first stage, 75% of FC will be allowed as a deduction from the rental income. Because there is a loss of £3,250, there is no tax reduction to claim. Therefore, £750 (£3,000 @ 25%) will be carried forward to use as a tax reduction in later years. The £3,250 loss will be carried forward to be offset against future rental profits in accordance with the current rules.
| Second Phase (2018/19) | Tax Reduction to be C/F |
Losses to be C/F |
||
|---|---|---|---|---|
| Rental Income: | £15,000 | |||
| FC: | £8,000 @ 50% | (£4,000) | £4,000 | |
| Other Expenses: | (£6,000) | |||
| Rental Profit/(Loss): | £5,000 | |||
| 2017/18 Loss B/F: | (£3,250) | (£3,250) | ||
| Taxable Profit/(Loss): | £1,750 | |||
| Tax Due: | £1,750 @ 40% | £700 | ||
| Tax Reduction: | £1,750 @ 20% | (£350) | (1,750) | |
| Revised Tax Due: | £350 | |||
| £3,000 | £ nil |
In the second stage, 50% of FC will be allowed as a deduction from the rental income. The tax reduction will be 20% of the lower of the disallowed financial costs (including the amounts brought forward) and the rental profits (after deducting the losses brought forward). Therefore, the tax reduction for the 2018/19 tax is 20% the lower of the following:
- Disallowed financial costs (including the amounts brought forward), i.e. £4,000 (from 2018/19) + £750 (from 2017/18) = £4,750;
- Profits of the property business for the year (after deducting the losses brought forward), i.e. £1,750.
Therefore the tax reduction is £350 (£1,750 x 20%). The amount eligible to carry forward to calculate the tax reduction in the following year is the unused amount of FC brought forward less the amount used in 2018/19, i.e. £4,750 - £1,750 = £3,000.
| Third Phase (2019/20) | Tax Reduction to be C/F |
Losses to be C/F |
||
|---|---|---|---|---|
| Rental Income: | £5,000 | |||
| FC: | £8,000 @ 25% | (£2,000) | £6,000 | |
| Other Expenses: | (£ 6,000) | |||
| Rental Profit/(Loss): | (£ 3,000) | £ 3,000 | ||
| £9,000 | £3,000 |
In the third stage, 25% of FC will be allowed as a deduction from the rental income. Because there is a loss of £3,000, there is no tax reduction to claim. Therefore, £6,000 (£8,000 @ 75%) will be carried forward to use as a tax reduction in later years, alongside the £3,000 brought forward from 2018/19, a total of £9,000.
| Final Phase (2020/21) | Tax Reduction to be C/F |
Losses to be C/F |
||
|---|---|---|---|---|
| Rental Income: | £ 15,000 | |||
| FC: | £ 8,000 @ 0% | £ nil | £8,000 | |
| Other Expenses: | (£ 6,000) | |||
| Rental Profit/(Loss): | £ 9,000 | |||
| 2019/20 Loss B/F | (£ 3,000) | (£ 3,000) | ||
| Taxable Profit/(Loss): | £ 6,000 | |||
| Tax Due: | £ 6,000 @ 40% | £ 2,400 | ||
| Tax Reduction: | £ 6,000 @ 20% | (£ 1,200) | £6,000 | |
| Revised Tax Due: | £ 1,200 | |||
| £11,000 | £ nil |
In the final stage, FC will no longer be allowed as a deduction from the rental income. The tax reduction will be 20% of the lower of the disallowed financial costs (including the amounts brought forward) and the rental profits (after deducting the losses brought forward). Therefore, the tax reduction for the 2018/19 tax is 20% of the lower of the following:
- Disallowed financial costs (including the amounts brought forward), i.e. £8,000 (from 2020/21) + £9,000 (from 2019/20) = £17,000;
- Profits of the property business for the year (after deducting the losses brought forward), i.e. £6,000.
Therefore, the tax reduction is £1,200 (£6,000 @ 20%). The amount eligible to carry forward to calculate the tax reduction in the following year is the unused amount of FC brought forward less the amount used in 2020/21, i.e. £17,000 - £6,000 = £11,000.
3 - Abolishment of the 10% Wear & Tear Allowance
Under the current system, landlords who are letting a fully furnished residential property can claim 10% of the total rental income (less any utilities) as a deduction instead of the cost of replacing furnishings, etc. The 10% Wear & Tear Allowance is currently available irrespective of the incurred expenditure. Therefore, it can be claimed even if there were no costs in respect of the replacement and maintenance of furnishings.
From 6th April 2016, the 10% Wear & Tear Allowance will be abolished. Landlords will however be able to claim a deduction for the actual costs incurred on furnishings on an annual basis. Please note that any capital expenditure is still not an allowable deduction from rental profits and will be added to the base cost of the property.
4 - Rent a Room Relief Scheme
Under the current rules, taxpayers who provide accommodation in their only or main home are exempt from tax on rental income if the gross rental income is £4,250 or less.
From 6th April 2016 the tax free gross rental income limit is due to be increased to £7,500.
If you are wondering how the changes announced in the Summer Budget will affect you, please do not hesitate to contact us.
The information in this article is believed to be factually correct at the time of writing and publication, but is not intended to constitute advice. No liability is accepted for any loss howsoever arising as a result of the contents of this article. Specific advice should be sought before entering into, or refraining from entering into any transaction.