In his recent Budget the Chancellor announced the government’s intention to “retain mortgage interest relief on residential property, but… restrict it to the basic rate of income tax.” He went on to explain that “to help people adjust, we will phase in the withdrawal of the higher rate reliefs over a four year period, and only start withdrawal in April 2017.”
However, the method by which the new tax restriction will be introduced may see many who currently regard themselves as basic rate tax payers as worse off.
It is also worth re-visiting the tax implications of company ownership in the light of the changes, as well as the change in corporation tax and income tax on dividends that were announced.
The amount of interest that will be excluded from taxable rental profits will be 25% from 2017/18, 50% from 2018/19, 75% from 2019/20 and all mortgage interest from 2020/21.
At the same time, tax payable will be reduced by the basic rate of tax applied to that part of the interest which was excluded from the calculation of taxable profits. In practice from 2017/18, 20% of 25% interest, from 2018/19, 20% of 50% of interest, from 2019/20, 20% of 75% of interest and from 2020/12, 20% of all interest reduce tax payable.
The end result is that from 2020/21 a landlord with a mortgaged property paying tax at 40% will obtain only 20% tax relief on the mortgage interest.
It is misleading to regard the extra tax as only payable by landlords who are currently higher rate taxpayers. Landlords who would be higher rate taxpayers if they could not deduct mortgage interest will also pay more tax under the new rules.
To provide a case in point, let us say a landlord has £50,000 rental profits before interest and £30,000 interest. For the sake of this example the personal allowance is £11,000 and the basic rate tax threshold is £43,000 in all tax years.
In 2016/17, said landlord will pay 20% tax on £19,000 of profits. A liability of £3,800. However, in 2020/21, a tax liability would arise of £20% on the first £32,000 of profits and 40% on the remaining £7,000 of profits. The total liability would therefore be £9,200. A reduction in this tax equal to 20% of the mortgage interest of £20,000 would leave £5,200 payable.
The Chancellor’s statement about the withdrawals of higher rate relief could therefore result in additional tax for many landlords that do not current pay tax 40%.
It may be prudent to pay off a mortgage particularly where other income generating assets are yielding interest or dividends which are taxed at a higher rate. For instance, if a landlord is paying tax at a higher rate tax on dividends held in a share portfolio then it would save tax to dispose of this share capital so as to pay down mortgage debt. The alternative would be to dispose of property entirely and reinvest in a different category of asset.
In general, tax can be saved by transferring assets into the hands of the spouse taxed at the lower marginal rate. However, under the new rules a tax saving will only be achieved to the extent that the spouse is a basic rate taxpayer before interest is deducted from rental profits.
Tax implications of company ownership
The new benefit of company ownership is that interest can be deducted in full from taxable profits. There is also the added advantage that the rate of corporation tax is set to reduce from its current level of 20% to 19% in 2017 and 18% in 2020.
Notwithstanding, any overall tax benefit could depend on the extent to which this extra tax relief will outweigh any tax on dividends. Once company profits are transferred to the company owners, the first £5,000 of dividend income will be tax free. This is on the basis that the taxpayer has no other dividend income. Therefore, a higher rate taxpaying landlord with a mortgage and a modest profits of about £5,000 could be much better off owning rental property through a company.
After the allowance, dividends will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. Therefore, a landlord wishing to withdraw profits from the company, will probably end up paying both corporation tax and income tax.
If there is no mortgage interest on the rental property, and the landlord prefers regular access to profits, then a company would probably result in more tax than personal ownership.
A further consideration is that the transfer of a property into a company creates a capital gains tax liability. Broadly, the capital gain is calculated as market value on transfer less original cost. This is particularly problematic because the transfer will not generate any proceeds. It is possible to come to instalment arrangements with HMRC for the payment of capital gains tax in these circumstances.
A further pitfall is that a capital loss can only be carried forward. Therefore if the property reduces in value after being transferred to the company, the loss on disposal could only be set against future capital gains, if any. By contrast if the property is not transferred to a company and falls in value but not below its original cost, then the result would be a lower capital gains tax liability.
There is a risk that the government alters regulation to cancel any advantage of company ownership in line with its state purpose of eliminating unfairness between landlords and homeowners.
A further drawback of company ownership occurs on disposal of the property. This is because a company mainly receiving rents would fail to qualify for entrepreneur’s relief. Consequently, corporation tax would be payable on the gains on the property, and capital gains tax would be payable on the gains on the share.
The overall tax would probably work out slightly less than tax on dividends. For instance the gain would be taxed at 20% in the company, and the net proceeds taxed at 28%. The overall gain would be 20% plus (80% of 28%) 24.4%, or 44.4%. This is considerably more than the straight 28% capital gains tax on property held personally.
In practice, a typical obstacle to tax planning requiring company ownership is the reluctance of banks to lend on property held by companies. The tax saving of transferring a property to a company will likely on deduction of mortgage interest from profits. It may be possible to lend money to the company, for instance through a personal mortgage or guarantee and deduct this mortgage interest against general income.
Where a landlord is able to leave rents accumulating in the company, a tax saving could be achieved by taking all profits as capital gains on eventual disposal. This form of planning carries some regulatory risk, particularly given the number of changes the government has made to property and company tax law in recent years.
Ray Coman, FCCA, CTA
Coman & Co. Ltd.