- Mortgage interest relief is being cut for individual landlords from 2017
- Companies continue to benefit from the full relief
- But running a company has its own costs and administrative issues
By Marc Shoffman for Thisismoney.co.uk
More landlords could set up companies to manage their buy-to-let portfolios amid fears that their profits will be hit by tax relief changes.
Landlords are anticipating a dent in their profits after Chancellor George Osborne issued new rules from April 2017 restricting tax relief on mortgage interest to the basic rate, currently 20 per cent.
Nimesh Shah, partner at accountancy firm Blick Rothenberg, said landlords could look to preserve some of their profits by setting up companies instead, but warns this would be costly for those with just one or two properties.
Preserving profits: Landlords could set up companies so they can keep the mortgage interest tax relief perks
Buy-to-let critics have long cited disparities in the tax system that mean landlords can offset mortgage interest against their tax bills and claim for wear and tear on properties – yet homeowners get no such perk.
The defence has been that this is a business principle; you only pay tax on the profit you make after your costs.
Critics argue that buy-to-let is an investment not a business and those who bought shares with borrowed money would not get the same relief. However, the concept of buy-to-let was set up with the idea that people would use mortgages to invest – no other investment is set up like that.
Landlords have also been accused of contributing to the housing shortage by locking out first-time buyers as they build up their own portfolios.
Whatever the rights and wrongs of the system, Mr Osborne has now attempted to ‘level the playing field for homebuyers and investors’. In his Summer Budget, he limited the amount landlords can claim as relief on mortgage interest to the basic rate of tax. A state that will be gradually reached over the next five years.
Landlords must pay income tax on rent that they receive. The amount paid is determined by their income tax band.
A basic rate taxpayer pays 20 per cent, while a higher rate taxpayer pays 40 per cent and tax is 45 per cent for additional rate taxpayers. Income from rent is added to personal income from other sources to decide the tax rate.
However, you can currently claim relief for interest on buy-to-let mortgage payments, allowing landlords to offset their mortgage interest against rental income and only pay income tax on the gap between the two – ie their profit.
Currently, someone who gets in £1,000 a month in rent and has an interest-only mortgage payment of £600 only pays income tax on the remaining £400 that amounts to their monthly rental profit. For a 40 per cent taxpayer this would mean a £160 tax bill, leaving them £240 profit.
But rules being introduced in April 2017 will see the tax relief reduced up to 2020 when it will be set at a maximum of 20 per cent.
At that point the investor in the example above would face a £280 tax bill, leaving them with £120 monthly profit.
Mr Shah says: ‘While the intention behind the changes may be to free-up housing supply by discouraging investors, individuals who rely on returns from their buy-to-let properties to top-up their income or use as a pension for retirement will now see their after-tax profits reduced.
‘With interest rates expected to rise sometime in the next year, buy-to-let landlords with significant debt will see a reduction in tax relief, which will naturally result in higher costs and lower after tax profits.
‘For example, a buy-to-let landlord with debt of £250,000 and interest charged at 3.25 per cent will see their annual income tax liability increase by approximately £2,000, if they are a 45 per cent taxpayer.’
One alternative, he says, is for landlords to manage the properties through a business.
Mr Shah says there are already many benefits to managing a buy-to-let portfolio through a company rather than as an individual, but changes to tax relief mean this route could be more effective for higher rate taxpayers.
What should you consider?
The limits on mortgage interest relief only apply to individuals.
Tax relief on mortgage interest was an attractive perk of buy-to-let.
A higher rate taxpayer could now get 40 per cent relief, but from 2020 will see that halved to 20 per cent.
They will be taxed on their rental revenue not their profits.
A company pays tax on its profits whereas an individual pays based on their income.
Companies pay a lower tax rate than individuals.
Corporation tax is currently 20 per cent and is due to drop to 18 per cent by 2020.
However, Mr Shah warns there will be tax charges such as stamp duty and capital gains tax that could be incurred when moving property into a company.
He explains: ‘If an individual transfers their property into a company they set up, there would be a deemed market value disposal for CGT purposes.
‘Therefore, if their buy-to-let property has gone up in value since they acquired it, they would have to pay CGT up to 28 per cent. Also, transferring a property into a company will give rise to a stamp duty charge.’
Do you need access to the money?
If you are running your property as an individual then any profits after tax will be in your name and easy to access.
It is slightly more complicated if you want to draw some money from a business.
Mr Shah says one option is to take the money out of a business in the form of a dividend.
But the ‘sting in the tail,’ he says, is that from next year dividend income will be charged at 7.5 per cent for basic rate taxpayers, 32.5 per cent for those on the higher rate and 38.1 per cent for the additional rate band.
This could be alleviated by the tax-free dividend allowance of £5,000 being introduced next year.
He says: ‘Overall, for buy to let investors it is probably best to set up a company if you want to roll up the money and don’t need access to it. You could just use it to build up a pension pot for when you retire.’
Are you ready to run a business?
The HMRC has very few requirements for individual landlords. They just have to complete a self-assessment tax return each year that takes account rental income and any expenses and reliefs.
But businesses have a range of responsibilities such as completing annual returns and accounts, all of which could mean paying for an accountant.
It could also get more complicated if you start involving shareholders and different directors.
Mr Shah says: ‘There are costs and hassle associated with running a company.
‘This is only really beneficial for serial buy-to-let landlords with a portfolio of at least 10 properties.’
He explains: ‘For serial buy-to-let landlords, they will probably look to operate their property businesses through companies as the same restrictions do not apply. In addition, the main rate of corporation tax is reducing to 18 per cent by 2020, further increasing the difference between corporate and personal tax rates, making companies more attractive.
‘However, for those with one or two properties, the associated cost and administration involved with operating a company is unlikely to make it worthwhile.’