Mortgage interest relief & options for buy-to-let landlords

Making a profit in the buy-to-let sector is a tough task in 2020/21, with a number of government changes denting profitability.

In particular, rental yields remain largely flat following the taper and subsequent replacement of mortgage interest relief.

Prior to April 2017, borrowing money through a buy-to-let mortgage was a tax-efficient method for residential landlords.

At that moment in time all residential landlords could deduct their mortgage expenses from taxable rental income

Since the change, sole traders and partners who fell into the higher (40%) or additional-rate (45%) income tax bands have been the worst hit.

From April 2017, the amount of relief available reduced at a rate of 25% a year before being replaced by a basic-rate (20%) tax credit in April 2020.

Residential landlords do, however, have options to negate the change to mortgage interest relief if they operate as a sole trader or a partnership.

Mortgage interest relief history

Buy-to-let landlords who had a mortgage on a property enjoyed significant tax relief by offsetting their entire mortgage interest payments.

That included all of the interest and finance costs associated with mortgage repayments.

Prior to April 2017, we would deduct these from a residential landlord’s rental income to calculate their profit before paying income tax.

Ever since then, the percentage of mortgage interest payments we can deduct from a landlord’s annual rental income decreased by 25%.

It is no longer possible to deduct any mortgage interest payments from rental income to gain tax relief at a landlord’s marginal rate of income tax.

Instead, the entire mortgage interest payment qualifies for a new basic-rate (20%) tax credit.

If you have a residential property portfolio, it would make sense to review your business structure if you have not already done so.

Mortgage interest relief only applies to residential landlords who pay income tax through self-assessment.

If you fall into the first bracket, incorporating your business would see you pay corporation tax at 19% on any profits.

That represents a considerable tax saving when compared to paying income tax at your marginal rate, typically 40% or 45%.

Evidence suggests more buy-to-let landlords have been incorporating their businesses since 2017.

That goes some way to explaining why landlords operating as limited companies are dominating the buy-to-let the purchase market.

Our corporate tax planning service can help you determine the most tax-efficient business structure to suit your buy-to-let business.

Switching from a sole trader business or partnership to a limited company, is not a one-size-fits all solution for all landlords.

For accidental landlords or those with smaller residential portfolios, selling properties may hold more appeal.

According to landlordtoday.co.uk, 37% of landlords plan to reduce their buy-to-let investment by selling at least one property this year.

Downsizing your property portfolio in 2020/21 will come with capital gains tax traps to be aware of.

Firstly, you may have to report the gain and pay any capital gains tax owed to HMRC within 30 days of the sale going through.

Secondly, in most cases, changes to private residence relief mean the final-period of exemption will fall from 18 months to nine months.

If you incorporated your business before the changes to mortgage interest relief kicked in from April 2017, doing nothing may pay off.

While there’s no doubt changes to mortgage interest relief have made buy-to-let less profitable, it is still generating returns on investment.

Figures from the Office for National Statistics show year-on-year rental yields in the South West rose 0.1% between January-March 2020.

Buy-to-let returns are based on fine margins and so any kind of annual increase, even an apparently small one, is significant.

To discuss your circumstances and get expert advice, contact us on info@stapletonsaccountants.co.uk or call 01363 773191.