Buy-to-let mortgages have been a useful tool for contractors over the years. The rental income ensures continuity of cash flow when they’re not working. When they are contracting, that same income is a great way to shore up their pension.
In recent times, inflation, kept down by the low base rate, has all but negated interest on ISAs. Responsible lending guidelines have turned the housing market on its head. It’s awash with would-be homeowners who can’t get mortgages, so need to rent instead.
This scenario has made property investment an even more lucrative alternative to traditional saving.
But that could all be about to change as the date for Osborne’s landlord tax gets ever closer.
Tax relief for residential landlords will soon favour the exchequer, not the landlord. As such, our concern is twofold:
- existing buy-to-let landlords are yet to take stock and grasp what the changes mean to them;
- contractors considering investing in property are getting dud advice, which could see them lose money.
This particular property ladder is the foundation of many contractors’ future prosperity. The rung advice today could cost thousands over the coming years. We want to ensure that your trajectory remains on the up and assure you that buy-to-let is still viable.
Understanding the imminent changes to tax relief on buy-to-let mortgages
As with many of HMRC’s tax changes of late, this one’s also punitive to smaller entrepreneurs. Up until now, landlords have only paid tax on the profit they make from buy-to-let.
As it stands, the tax return on your investment business looks like this:
- you take out a mortgage loan on a residential or commercial property;
- the interest only mortgage repayment costs you ‘x’ amount a year;
- you receive rental income of ‘y’ from your tenant;
- you pay tax on the difference, i.e. y − x = z, where ‘z’ is your profit, the taxable income.
That’s going to change. From April 2017, you’ll now pay tax on the full amount of ‘y’.
In effect, you’ll pay tax on turnover, not profit.
The new calculation is even at odds with limited company payment structures. The best way to visualise what the changes to landlord tax relief mean is by using an example.
Landlord’s tax relief: a Conservative estimate
No one predicted the buy-to-let bomb shell that George Osborne dropped on us in 2015. Even then, the implication was that only the higher rate tax payer would be culpable.
And as good as his word, every landlord who pays 40% or 45% income tax will pay more. But so will many basic rate taxpayers, a factor that the ex-Chancellor didn’t tell us.No one predicted the buy-to-let bomb shell that George Osborne dropped on us in 2015 Click To Tweet
That’s because the new equation will push many lower-earning landlords up a bracket. Not being able to deduct the cost of mortgage interest from their income will see to that.
The bottom line is this: only the most wealthy will benefit from the changes to landlord tax relief.
Yes, they may have as many properties as hardworking contractors, if not more. But they don’t have to take out a mortgage; the wealthiest landlords pay cash. And no outstanding mortgage means no bill from the tax man for claiming relief.
What you as a landlord need to work out is whether rental income after tax is more than your mortgage repayment. Here’s the example where the landlord pays 40% income tax:
Now vs 2020: a comparison example
Let’s imagine the income you receive from your buy-to-let mortgage is £19,000. You’ve taken out an interest-only mortgage, the repayment vehicle of choice for landlords. That interest, what you pay back over the year, is £12,000.
As of now, you only pay tax on the difference between the two amounts. So £19,000 – £12,000 is £7,000. You pay 40% tax on that difference, which means £2,800 for the tax man, £4,200 for you. Happy days.
By the time 2020 rolls around, it’s all change
We’ll use the same figures for the future calculation. Your tenant is still paying you £19,000; your interest remains at £12,000; you still pay 40% tax.
But in 2020, you won’t just pay tax on the 40% difference; you’ll pay it on the full £19,000 rent. The new rules for relief don’t allow you to deduct the cost of the mortgage interest.
The effect is that you’re paying tax on profit that you’ve not received.
Yes, HMRC is giving landlords a tax credit equivalent to basic-rate tax on the interest. But that in no way makes up what you’ve lost.
So here’s the new calculation.
You pay 40% tax on the full £19,000 income (£7,600), less the 20% credit (20% of £12,000 = £2,400). This means HMRC gets £5,200, leaving only £1,800 for you.
The tax bill for this element of your business has increased by 86%!
If interest rates go up this scenario worsens; you could end up making a loss, all other things being equal.
Underhand, over-taxed, bumbling fee
If you’re a contractor who’s also a landlord, get professional tax relief advice. It’s not just those already in higher tax brackets who’ll feel the impact of the new rules. They may also push contractors who keep salary and dividend income low up a notch.If you're a #contractor who's also a landlord, get professional tax relief #advice. Click To Tweet
You may think your first port of call is a specialist mortgage broker. If you’re only considering buy-to-let, that’s not a bad idea. They can advise you on Stamp Duty, fees and how much interest you’ll pay on a new buy-to-let mortgage.
But the person from whom you’ll most benefit is your accountant. They can see the big picture and how the changes to tax on your rental income will affect your overall tax status.
For many contractors, living off rental income in retirement is their ultimate dream. Don’t let the new changes to what you can claim against your tax bill turn your future into a nightmare. If you don’t act now, it won’t just be sleepless nights you have to worry about.
Author: John Yerou
John Yerou is the owner and founder of Freelancer Financials; a trading style & trade mark of the award winning Mortgage Quest Ltd. One of the most recognised names in providing mortgages for contractors and freelancers across the UK.
In 2004 John began his career in Financial Services as an independent mortgage adviser and broker. John has been instrumental in negotiating bespoke underwriting for contractors with high street lenders.
His presence in the industry as a go-to expert is growing by the day and he is regularly cited and writes in publications both locally and nationally.