Buy-to-let Mortgage Interest Relief
In recent years, we have seen massive growth in the private rental market, prompting increased demand for buy-to-let mortgages. This will likely continue in the short term, with many people struggling to cover mortgage payments and opting for rental arrangements. While many landlords hold property in their name, changes in mortgage interest relief have reduced the benefits for higher-rate taxpayers.
Consequently, several companies are promoting tax-efficient schemes whereby private residential properties are transferred into a company. The attractions are simple; the potential to offset total mortgage interest charges and see profits charged at corporation tax instead of income tax rates. We will now look at a recent scheme that came under public scrutiny and could leave individuals open to significant penalties and tax charges.
Change in mortgage interest relief
Since April 2020, the maximum mortgage interest relief a landlord can claim was reduced to 20%. Brought in as a means of reducing mortgage interest relief for higher rate taxpayers, currently 40%, it prompted a significant change in the approach to private rental properties. The following examples show the historical calculation for mortgage interest relief compared to the situation today:-
Rental income: £20,000
Mortgage interest: £16,000
Old mortgage relief process
The previous mortgage relief process was relatively straightforward; landlords were allowed to deduct mortgage interest from their gross rental income. In this example:-
- A basic rate taxpayer would pay 20% of £4000, which equals £800
- A higher rate taxpayer would pay 40% of £4000, which equals £1600
New mortgage relief process
Under the new system, all landlords pay tax on their gross rental income with a tax credit of 20% against their mortgage interest. Using the above scenario, the situation is now as follows:-
- A basic rate taxpayer would pay £4000 on their rental income and offset 20% of the mortgage interest, which equates to £3200. Consequently, the net tax charge is £800, precisely the same as under the old system.
- A higher rate taxpayer would pay £8000 on their rental income and offset just 20% of the mortgage interest, which equates to £3200. In this situation, the net tax charge is £4800, which is £3200 more than under the old system.
As companies can offset finance charges against their income, with profits charged at corporation tax rates, in theory, there is the potential for significant savings. However, as ever, the devil is in the detail!
The downfall of the proposed scheme
The idea of transferring residential property from the landlord’s name into that of a company and enjoying the various tax benefits was obviously very attractive to many buy-to-let investors. What is referred to as the “Substantial Incorporation Structure” proposed the following structure to crystallise tax efficiencies:-
- Landlord sets up a new company, into which their private rental properties are sold in return for shares.
- Completion of the transaction is deferred, which means that the landlord remains the registered owner of the properties, although the property is transferred into a trust. The landlord is the trustee, and the company is the beneficiary.
- The company promoting the scheme claimed that incorporation relief applies and, therefore, there was no capital gains tax charge on the transfer.
- Where applicable, the landlord and their spouse would be in partnership, allegedly prompting SDLT partnership rules and, therefore, no SDLT to pay.
- The landlord continues to repay the mortgage, while the company agrees to reimburse/indemnify the landlord. So, behind the scenes, the company claims tax relief on the “mortgage payment” as if they were company borrowings.
The scheme in question also left open the option to issue shares to the landlord’s children, which had no initial value. Within what they refer to as a “smart company”, the value of the shares would increase over time, thereby removing growth in the value of the properties from the landlord’s estate.
Under the proposed scheme, the company would pay corporation tax of 25% on rental income, less the cost of mortgage interest. This equates to 25% of £4000, i.e., a tax charge of £1000, a saving of £3800 if the rental property had been held in the name of a higher rate taxpayer. Unfortunately, it didn’t take long for several potential issues to emerge!
Areas of concern
There has been a degree of public disagreement over elements of the above scheme, with particular concerns in the following areas:-
Mortgage terms and conditions
As we all know, the buy-to-let and business mortgage markets are very different, which is why the consent of mortgage lenders is required to transfer ownership of any property. Consequently, moving ownership of the property from the landlord’s name into that of the trust could put the mortgage into default.
Tax bill
With the above scheme, the individual is still paying interest on the mortgage, although the company reimburses this. As the property is no longer owned by the landlord instead part of a trust, they are unable to claim tax relief on the mortgage payments. To make matters worse, the £16000 payment from the company to reimburse the individual for mortgage payments is taxed at 40%, or £6400 a year.
Capital gains tax, SDLT and ATED returns
There is a solid argument to suggest that the scheme structure would create a chargeable event and an SDLT liability, which could, in some cases, run into combined charges of hundreds of thousands of pounds. If you add penalties for failing to file an ATED return, the additional costs are starting to add up!
Substantial incorporation structures and regular incorporation
We now move into the realms of potential tax avoidance instead of tax reduction. With a standard incorporation structure, the legal ownership of the property would be held by the company. This would shield those previously having rental properties in their name from legal action from tenants. With the “substantial incorporation structure”, there is no additional benefit as the company does not own the property. Consequently, it could be argued that this is a case of tax avoidance, which would reverse any tax benefits.
If it looks too good to be true……..
On the surface, the proposed scheme to reduce tax liabilities for landlords holding property in their own name seems interesting. It is only when you begin to dig a little deeper, pulling away at the financial threads, that the potential benefits start to unravel. While there is still some debate as to whether various elements of the scheme are valid, several points have been made concerning property ownership, payments, tax relief and other issues.
Buy-to-let Mortgages interest relief – Summary
While there are ways and means of managing your tax liabilities with regard to a rental portfolio, the transfer of property into a company/trust, in the above manner, could be fraught with financial dangers. It is essential to take the advice of your accountant at the earliest opportunity to ensure that you are doing the right thing for your situation.
We have several experts in the office available to discuss your concerns and address any questions you may have. We would welcome the opportunity to chat with you; please feel free to contact us at any time.