These changes include the removal of the higher rates of tax relief for private landlords with Buy to Let mortgages and a cut in the relief available for property maintenance.
When they come into force, many private landlords could find themselves out of pocket. So, are you prepared for what lies ahead?
Changes to Wear-and-Tear Relief
The first tax relief changes to come into effect will be for wear-and-tear deductions. At the moment landlords can claim an automatic 10% tax deduction to cover the costs of maintaining their property.
From April 2016, it will only be possible to claim relief for the actual cost of repairing or replacing furnishings during the tax year. If your rental yield is low to begin with, this could make a significant impact on your earnings.
Increase in Rent-A-Room Relief
On a positive note, private landlords who only rent a room in their home look set to gain. The summer budget also increased the level of rent-a-room relief from £4250 per year to £7500.
This means those who rent a room in their house or flat to a lodger will be able to keep up to £7500 of the rent tax free. That translates to a monthly rent of up to £625 per month.
An End to Higher Rate Tax Relief
However, the biggest change in tax relief for private landlords will come into force from April 2017.
From this date the tax relief available for Buy to Let mortgage interest payments, mortgage fees and other related financing costs will be gradually reduced from 40% or 45% a maximum of 20% by 2020.
These changes will hit landlords in the higher tax brackets hardest, as they are the ones who benefit from the higher rate of relief. Private landlords with numerous properties are likely to feel the impact acutely.
The Relief Will be Phased Out Gradually
The good news is that until 2020 the tax relief on mortgage finances will be phased out gradually.
From 2017 landlords will be able to deduct 75% of their finance costs from their tax bill. At the same time, they can claim the 20% tax relief on the remaining 25% that is taxable.
From 2018, the finance cost deduction reduces further to 50%, with the other 50% eligible for tax relief at 20%. In 2019, the available deduction will be 25%, with the rest eligible for tax relief at 20%.
How This Could Impact You
To see how this could affect you, consider the following calculations for a 40% taxpayer with a yearly income of £9600 and annual finance costs of £6000:
Tax bill 2016: £1440
Tax bill 2017: £1740
Tax bill 2018: £2040
Tax bill 2019: £2340
Tax bill 2020: £2640
As you can see, under the new rules, the tax payable would increase by £1200, an 83% rise in 5 years.
For some private landlords, the changes in tax relief will mean an increase in rents for tenants. However, other landlords may decide to bank any capital gains they have made and leave the rental sector completely.
How you decide to manage the situation will depend on your personal circumstances. But there is a way to avoid some of the financial pain ahead.
Consider Setting up a Rental Business
One way to manage the situation and keep tax bills under control is to set up a rental business.
According to accountants PwC, private landlords could decide to transfer one or more of their properties into a company structure. This could significantly reduce the total tax rate.
The reason why this could be a good idea is that companies are taxed on their profit, not their income. By contrast, private landlords pay tax based on their income no matter what their expenses.
The big advantage of running a company is that if the profit is lower, the tax bill is lower as well. Companies don’t have to pay tax if they don’t make a profit.
However, when tax relief for mortgage finance is reduced in 2020, some landlords may find themselves paying tax even if they are losing money. That could be a recipe for disaster!
Look at the Figures
Let’s imagine a rental situation in 2020, when interest rates will probably be higher than today. The landlord pays a higher tax rate and owns a property worth £100,000. He or she has an 85% LTV mortgage at 5% interest.
In 2020, under the new rules, the rate of tax payable would be 106%, meaning the landlord would make an annual loss of £100 on the investment.
Now imagine the same property was incorporated into a business. Then the landlord would pay tax at a rate of 49.2% and make an annual profit of £888. The difference is almost £1000 per year.
If the interest rate payable on the mortgage were 6%, a private landlord would pay 186.7% tax, while a rental business would pay 49.2%, the same percentage tax as before.
A Few Things to Think About
However, before you rush to call your solicitor, there are some additional aspects of business tax to consider.
Business owners have to pay additional stamp duty and capital gains tax, which could also affect profits in the long term. This is especially important to think about if you set up on your own, or only have a handful of properties.
Additional Stamp Duty
If you set up as a sole trader you would have to pay stamp duty again on the ‘incorporation of the business’ based on the cost of the property.
The situation is better if you have a business partner. If your business is a partnership, you could be eligible for some stamp duty relief.
The more property your business owns, the better (in terms of stamp duty). If the business owns more than 6 properties, it is classified as a commercial property business and will only be liable for 4% stamp duty on the sale of the property.
Consider Capital Gains
However, rental companies also need to consider capital gains tax. Private landlords have to pay 28% capital gains tax on the profit of their property when they sell up.
For companies, the percentage tax is higher – 49% – so it is important that this is taken into account. Will the increased profits from rental yields be enough to balance the loss of profit when you sell?
If you rely on rental yields to make a profit on your property, you may find that incorporating your properties into a business makes financial sense.
But if you rely on capital gains to make the investment worthwhile, starting a business might not be the right option.
No matter what your situation, it is important to consider the impact that the new tax rules will have on your finances in the next few years, and take steps to address them before it’s too late.