Another nail in the coffin for rental property

Are you a landlord with a mortgage on your rented out property? If you are, even basic rate tax payers may fall foul of the new tax laws that come into effect from April 2017.

What’s changing for rental property investors?

At the moment you are able to fully deduct the cost of your buy-to-let mortgage interest payments from your gross rental income. The remainder is potentially liable to tax.

From April 2017, you will no longer be able to claim this tax relief. Instead, you will have to pay tax on all your rental income with a basic rate tax deduction on the interest payments.

Confused? Here’s an example.

Tax relief on buy-to-let mortgages is changing

Let’s say Mike’s rental property generates £18,000 per annum and his mortgage interest payments are £10,000 per annum.

Tax on rental income: The present

Under current legislation, Mike only has to pay tax on £8,000 of his rental income (£18,000 rental income – £10,000 interest payments).

  • Because Mike is a higher rate (40%) tax payer, he’s liable for £3,200 tax and pockets £4,800;
  • If he was a basic rate (20%) tax payer, Mike would be liable for £1,600 tax and pocket £6,400.

Tax on rental income: From April 2017

Under the new legislation, from April 2017 Mike will be liable for tax on the full £18,000 rental income, minus a deduction of basic rate tax relief on the £10,000 interest payments.

  • As a higher rate tax payer, Mike will be liable for £7,200 (40% of £18,000) minus £2,000 (20% of £10,000), which equates to a tax bill of £5,200 and leaves him with just £2,800 ie 42% less than under the current tax rules;
  • If he was a basic rate tax payer, he would be liable for £3,600 (20% of £18,000) minus £2,000 (20% of £10,000), which equates to a £1,600 tax bill, leaving him with £6,400 ie the same as now.

It would seem that George Osborne’s announced new legislation only hits higher rate tax payers, right? Not necessarily!

Why the rental income tax changes affect both basic and higher rate tax payers

It is possible for basic rate tax payers to fall foul of the new rules too, for 2 principal reasons:

Reason 1: If, as is often the case, your rental income tips you into the higher rate tax threshold, significantly more of that income will be taxed at 40% under the new legislation.

If (or rather when) your mortgage rate then rises, you will, as a higher rate tax payer, feel the impact of the new tax rules even more.

Let’s say Mike’s interest payments go up from £10,000 to £12,000. As a higher rate tax payer, he will still have the £7,200 tax liability (40% of his £18,000 rental income) minus what now becomes £2,400 (20% of his higher £12,000 interest payments).

Even though Mike’s tax bill will be slightly lower than before the mortgage rate rise (£4,800 compared to £5,200), under the new legislation he will only be left with £1,200 in his pocket ie 67% less than under the current rules.

Reason 2: If you have a high mortgage relative to your rental property’s value (your loan to value ratio), you’ll also be left with less money in your pocket under the new rules.

Like Reason 1, your mortgage interest payments will be higher and the amount of tax you can offset will be lower…a situation again exacerbated even further if/when mortgage rates rise!

But it’s the property’s capital growth that matters…isn’t it?

Mortgage payments aren’t the only costs to consider. When you add the associated costs and risks of actually running a rental property, it makes it harder to justify rental property as an investment vehicle (for higher rate tax payers in particular).

I hear people shouting “it’s the capital growth that matters” but that ignores the cost of remortgaging, void periods, ongoing maintenance, replacing carpets, boilers and white goods…it all adds up and has to be paid for before you realise the capital growth by selling the property.

Oh, and did I forget to mention, you’re potentially liable to capital gains tax (CGT) on the sale of the property too!

Is this the Government’s answer to increasing the housing supply for those who wish to own their property…by making property less attractive as an investment vehicle, therefore lowering demand on the housing market? Let us know your thoughts by adding a comment below.

* Assumes rental income stays the same
If your rental property is unencumbered by a mortgage, then the new legislation doesn’t affect you.

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