George Osborne unveiled a shock tax change in 2015 which will remove landlords’ ability to deduct the cost of their mortgage interest from their rental income when they calculate a profit on which to pay tax.
In effect, the Government wants to tax landlords on their turnover rather than profit, meaning that tax will be payable on nonexistent income. For some, tax rates will exceed 100%: landlords will have to pay all of their profit in tax, and then pay more tax still. The tax increase will be phased in from 2017 and fully implemented by 2020.
All higher-rate taxpayers who own buy‑to‑let properties on which there is a large mortgage will pay substantially more tax. Some current basic-rate taxpayers will also be hit, because the change will push them into the higher-rate tax bracket.
Those who are worst affected will see:
- the actual tax they pay on their investment rising twofold or more;
- the tax rate payable rising above 100%, meaning that more than all of their profit is paid in tax;
- a degree of tax that pushes them into loss, making their investment financially unviable and forcing them to increase rents sharply – or sell.
What is also becoming clear is that worst hit will be those modest, middle-class savers who have prudently chosen to invest in buy‑to‑let, often alongside pensions and Isas, as a means to supplement their income.
The mechanism of the Government’s tax attack is the removal of landlords’ ability to deduct the cost of their mortgage interest from their rental income when they calculate a profit on which to pay tax.
So very wealthy landlords who do not need mortgages are untouched.
Smith & Williamson has calculated that any higher-rate taxpayer landlord whose mortgage interest is 75% or more of their rental income, net of other expenses, will see all of their returns wiped out by 2020.
So mortgage costs above 75% of rental income will mean the buy‑to‑let investments become loss-making.
For additional-rate (45%) taxpayers, the threshold at which their investment returns are wiped out by the tax is when mortgage costs reach 68% of rental income.
The investors worst affected are therefore likely to be those who have bought recently with large mortgages. Low-yielding properties, such as those in London and other parts of the South East, where rents are comparatively low relative to property prices, will also be exposed. That is because rental income is likely to be lower relative to investors’ mortgage costs.
Here is a worked example assuming you, the landlord, pay 40% tax.
Your buy-to-let earns £20,000 a year and the interest-only mortgage costs £13,000 a year. Tax is due on the difference or profit. So you pay tax on £7,000, meaning £2,800 for HMRC and £4,200 for you.
Tax is now due on your full rental income of £20,000, less a tax credit equivalent to basic-rate tax on the interest. So you pay 40% tax on £20,000 (ie £8,000), less the 20% credit (20% of £13,000 = £2,600), meaning £5,400 for HMRC and £1,600 for you. Your tax bill has therefore gone up by 93%.
Now, say Bank Rate – and in turn your mortgage rate – rises by a small fraction, lifting your mortgage cost to £15,000, while your rent remains at £20,000.
You will have to pay £5,000 tax in this scenario, so you make no profit at all.
Some buy-to-let investors remain unaware of the tax bombshell poised to wreak havoc on their finances. Accountants, mortgage lenders, brokers and other professionals are themselves still working through the ramifications. If you have any questions regarding the forthcoming changes, you should speak to your financial adviser or accountant. For further information, see the government website below: