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Budget 2015 Buy to Let Mortgage Interest Tax Restriction

29th Aug 2015

Category: Property headlines

Tagged: tax, Legislation

Effect on Buy to Let landlords

Hello fellow property enthusiasts.  I am going to focus on some of the consequences for landlords of the latest Budget 2015 announcement about Higher Rate Taxpayers only getting 20% Tax Relief on their Buy To Let Mortgage Interest.  

Did you know, you could be a Lower Rate Taxpayer, and suddenly find that your Work Bonus will be taxed at 40%, all because of this tax change!?  Read on, but maybe go and get a Cup of Tea, I will be exploring this in some detail... You might also want a calculator!

I will not, in this blog, go on to talk about the unintended consequences of this Buy to Let Tax Grab - Which may very well mean increased rents, increased government expense on short term accommodation for Social Housing Tenants, degradation in housing standards as landlords defer repairs/improvements and increased evictions.

"It's Okay, only Higher Rate Taxpayers will pay more tax'... Well... no, actually!

The Tax Treatment of Interest on loans for residential property owned by individuals is fundamentally changing - It will no longer be a deductible expense, for any taxpayer!  The Budget 2015 has indicated that instead of Interest being a deductible expense, your Interest expense will be used to calculate a new form of Tax Relief.  "That's Okay then, I still get Tax Relief".  True, but, your income as it will be declared on your Tax Return will increase by your current yearly Buy to Let Interest expense.... That's right, your taxable income could grow hugely, but it doesn't mean you'll be richer!  

Let's do an example and bring this to life.  Your name is now Ben/Laura, take a pick(!), and you earn £41,800 at your 9-5pm job.  You also do quite well and get a £1,500 Bonus!  When you got married you moved into your partner's house and you rented out your home as you found it difficult to sell.  You rent it for £600 a month and pay Interest of £500 a month on your mortgage.  You have management and general repair costs of, on average, £100 per month.  Neat example, because you make no money!  You have therefore never before declared Rental Profits because £600 - £500 - £100 = £0 Rental Profits.  You have never had to pay HMRC tax for making no money from your rental property, "Of course, who would have to pay tax when you don't make profits?!".  Well, from 2017, you! You will start paying tax, and in 2020 with all other income still being the same, you'll have to pay £1,040 in tax for your rental property, compared to 2016 when you would pay £0.

There's an obvious problem isn't there.  Your yearly profits from property are ZERO, yet you will have a tax bill of £1,040.  It's lucky you got that Bonus!  After tax and ignoring National Insurance, you'll have £1,200 in your bank account from your bonus, but, instead of treating your family for your extended hours at work recently, you'll simply pay most of it straight to the tax man to settle the tax bill on your £0 Rental Profits.  If you haven't spilt your tea already, then let's see if I can show you some more of the consequences, like your increased risk exposure to Interest Rate rises.  I'm going to get technical now, so this bit from here is for the enthusiasts, but every Buy to Let property owner really should understand the following.

2020 V 2016 Tax Treatment

A tax on Middle Earners... Not the wealthy as the Government has portrayed

As widely discussed by the media and government representatives at the time of the Budget 2015 Announcement, this change is to only affect 'Higher Rate Taxpayers'.  It should have actually said, 'Higher Rate Taxpayers and Newly Created Higher Rate Taxpayers' as the Ben/Laura example demonstrates. We, as a general public, never feel too bad when tax changes affect the highest paid earners, because we believe they can afford it.  However, what I will demonstrate below is that this new Buy to Let Tax Treatment of Mortgage Interest costs, hits the property investing Middle Classes hardest and leaves some Lower Rate Taxpayers in a very tricky situation when it comes to finding the cash to settle a manufactured Tax Liability. 

The graph below shows the Marginal Tax Rate that you as a Taxpayer would pay as your salary increases, given a rental income of £18,000 (A London rental property or a couple of semi-detached properties in the Midlands).  As you can see from the Blue line, as your salary increases, the proportion that you pay in tax increases, this is because more and more of your earned income is taxed at the Higher Rate of Tax of 40%.  The Red line, shows you how the Income Tax world will look in 2020, when the effects of the Budget 2015 Announcement are in full force (They commence in 2017, but the change is only partially introduced, they are 'tapering in' the tax change over 4 years, so only One Quarter of the affects are felt in 2017, then a Half of the affects in 2018, Three Quarters in 2019 and Fully in 2020). 

I have labelled the graph with the percentage increase in tax payable for a Lower Rate Taxpayer earning £29,090, a 'only just' Higher Rate Taxpayer earning £40,000 and a Higher Rate Taxpayer earning £80,000.  Each of these taxpayers sees an increase in their taxes, but proportionately speaking, taxpayers who had an income very near the Higher Rate of Tax Threshold get hit the hardest.... 37% Increase in their Income Tax Bill, in this example.  WOW!  The Lower Rate Taxpayer now becomes a 'Manufactured Higher Rate Taxpayer', meaning any modest Bonus they now get from work on top of their £29,090 salary, will be taxed at 40% as a consequence.  Who would have thought that your property investment strategy could expose your Bonus to the higher rate of tax!  You see, this change really isn't just about Higher Rate Taxpayers.  It impacts taxpayers who have leveraged property investments the hardest.  Arguably, these are ordinary people trying to create for themselves a pension pot, something to fall back on, or a married couple who couldn't afford to sell when houses prices dipped during or after 2007.  'Leveraged' property investors therefore have huge exposure to this tax change, and if you're highly geared, meaning your loan makes up a lot of the value of the property (think £90,000 loan on a £100,000 house), then you really need to sit up and pay attention!

For a landlord with no borrowing, think either of the super-rich or super cautious, then there is no tax consequences on these landlords because they have no Interest Expenses.  That means, this is very definitely not a tax change on the highest earners.  The riskier you are as a landlord (the proportionately more debt you have, i.e. higher Loan to Value mortgages) the more you will pay in tax.  It's therefore a tax change on the Risk Takers.

Effective Tax Rate

Increased RISK from Interest Rate Rises

You will have been aware that as interest rates rise, your risk increases... The risk of not being able to afford the mortgage repayments or interest payments.  With Bank of England Base Rate still at its longstanding low of 0.5%, mortgages have never been so cheap!  Consequently, house prices have never sustained at such a high level for so long!  (Getting into another Blog article that is tempting to drift into!) High house prices and cheaper debt have meant that borrowers have taken on extra Risk, because it hasn't cost that much in monthly payments to do so.  However, if that Risk begins to be Realised, then investors and homeowners will begin to really feel the pinch.  In an inflationary environment, prices across the board will rise, eggs, bread, fuel and Interest Costs will all go up. We all hopefully knew or had some appreciation of that, but now for a leveraged buy to let property investor the Risk associated with Interest Rate rises just got leveraged!  "What?" you might say. 

Well, what I mean is that your Interest Expense used to give you full tax relief, but it will in future only give some investors partial tax relief.  So £1 of Interest expense for a higher rate taxpayer actually cost you 60p in real terms, because you were able to deduct the £1 against your rental income and save 40p in tax.  That 40p saving meant you had some cash in reserve to pay for any Risks Realising... Boilers breaking, Court costs, rent not being paid and of course interest costs rising.  In 2020, Manufactured Higher Rate Taxpayers will only save 20p in tax, so £1 interest expense will actually cost 80p.  So the cost of servicing debt, just went up 33% from 60p to 80p in the pound.  That's quite an increase when you look at it like that!

The graph below looks at the impact of the Mortgage Interest Relief restriction announced in Budget 2015 by George Osborne in an environment of Rising Interest Rates.  i.e. The Risk of interest rates rises being realised, and how this affects an investor's 'Breakeven Point'.  By Breakeven Point, I mean the point at which your cash flow goes from positive to negative, ie. you start losing cash!  What I am demonstrating below, is that your Breakeven Point 'shifts to the left' on the graph, meaning you have less room for interest rate rises before losing money and therefore your Risk and exposure to future interest rate rises INCREASES with this tax change.  In the example below, the interest rate on your mortgage only now needs to increase to 4.65% before you start losing money, whereas prior to this Budget Announcement, the interest rate had to rise to 6.7% before you started to lose money.  The Breakeven point is much closer and therefore more likely to become a reality!

Mortgage Interest Relief 401

Increased RISK = Higher Mortgage Costs

Have you considered yet, that as a leveraged property investor with increased exposure to the risk of interest rate rises from the removal of your ability to deduct your interest costs against your rental income that you are now more risky to the banks?!  If you are more risky, then you have to pay more.... Penny is dropping isn't it.... It's all very cyclical! Tax rules change, you become riskier.  The riskier you are the higher the interest rate you pay.  The higher the interest rate you pay, the more of your rental income is lost to interest and tax.  The less cash produced by the rental house, the riskier you are.  (Dizzy?!) The riskier you are, the more you pay in interest costs, again!  What I am trying to communicate, is that you now have a very real sensitivity to interest rate rises, leveraged by the way your tax is calculated!  You are now interest geared and tax geared = You are a Riskier borrower = Extra cost (and tax). 

The Graph below demonstrates that as interest rates rise, or the cost of borrowing increases, the LTV of the loan you can have before you start to lose money significantly decreases. i.e. You cannot borrow as much before you start to lose money.

Ltv V Interest Rate Breakeven

Summary

Regardless of what type of taxpayer you are, you should be considering the impact of this tax change.  If you have lots of debt supporting your property investment strategy, then you are the target of this tax change and you will be paying more for that debt and you will be paying more in tax.  As per the opening example, HMRC may still be asking for a significant regular contribution even when you are currently making no money!

I'm not Ben or Laura, so what is the effect on me?

Comfort Landlords, feel free to get in touch and discuss your portfolio with me, we should talk and examine the structure of your borrowings.  If you are a guest reading this Blog entry, welcome!  There are loads of great resources out there on the net and loads of people are talking about the extra cost of this tax change.  So, I would like to link a couple of places that you should visit and consider.

1) On this link you can input your salary and rental income and look at the possible impact/cost on you of this change.  The 'Settings' of the website can be changed, and personally I would alter the settings to my own assumptions, but that is just my technical view of what assumptions are best applied.  For the purposes of calculating the additional cost however, it works great and gives you a good idea of the ball park increase. How much will the tax change cost me?

2) Some landlords feel compelled to campaign against the Budget Announcement and want the tax change debated in Parliament.  If you would like this debated in Parliament please sign the petition.  100,000 signatures means the topic will be debated. Government Petition

Mortgage Interest Relief 40 Ltv Breakeven Additional Tax Payable As Income Increases

Phil Ashford

Comfort Partner

An experienced Chartered Accountant and a Founding Partner of Comfort Lettings.

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