Mortgage interest restriction (aka section 24) - How to mitigate the tax liability

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Background

Prior to the year ended 5th April 2018 (the 2017/18 tax year), landlords and property investors were allowed to offset 100% of mortgage interest against their property income for tax purposes. From the 2017/18 tax year onwards, the amount of mortgage interest that will be allowed to be offset against property income as a deduction was reduced to 75%. There has been and will be a further reduction of 25% each year until 2020/21 when no allowance will be made to offset mortgage interest against property income in order to calculate the tax due.

HMRC are replacing the deduction with a basic rate (20%) tax reducer, where the amount of tax payable on the rental income profit is reduced by 20% of the mortgage interest paid in the tax year. This is being phased in by 25% each year in line with the phasing out of the income deduction.

In effect, this change means that landlords’ taxable income levels go up and they only receive basic rate tax relief on the mortgage interest they pay, even if they are a higher or additional rate taxpayer.

As well as the expected increase in tax liability on property income for high earners, there are a few extra specific impacts we will outline:

  • Loss of child benefit

  • Loss of personal allowance

  • Loss of pension allowance

Loss of child benefit

Parents can claim child benefit, but where individuals have income over £50,000, child benefit is reclaimed from them often as a tax charge in their tax return.

If an individual’s income was just under £50,000 prior to the restriction on mortgage interest relief, the restriction may result in their income going over £50,000 and part or all of the child benefit being reclaimed.

Loss of personal allowance

If an individual’s income exceeds £100,000 in a tax year, their personal allowance is reduced by £1 for every £2 their income exceeds £100,000. As the personal allowance is £12,500 in the current 2019/20 tax year, this means that there is an effective tax rate of 60% on income between £100,000 and £125,000.

If an individual’s income is around this level, the restriction on mortgage interest relief can result not only in not getting full tax relief on mortgage interest, but also having some or more income taxed at a rate of 60%.

Loss of pension allowance

Individuals get tax relief when they make contributions to their pension, up to the lower of the pensions annual allowance (£40,000) or their level of earnings.

High earners are subject to a reduction of their pensions annual allowance where their ‘adjusted income’ (being taxable income plus pension contributions made both personally and by an employer) exceeds £150,000. The annual allowance is reduced by £1 for every £2 the adjusted income is over £150,000, down to a minimum of £10,000.

If an individual’s income is around this level, the restriction on mortgage interest relief can result in the annual allowance being restricted.

What can be done to counteract the additional tax liability caused by the changes?

A few suggestions are outlined below:

  • Reduce the mortgage interest

  • Transfer rental income to a spouse

  • Change of use of the rental property

  • Transfer property into a limited company

  • Other tax planning

Reduce the mortgage interest

This may seem like both an obvious and potentially unrealistic point as individuals don’t just have mortgages for the sake of it, but depending on individuals’ particular circumstances, it may be more beneficial to pay off mortgages now than to buy more properties and borrow money to do so.

Be aware that if the spouse/civil partner needs to be added to the mortgage, there may be a stamp duty implication, as the assumption of a mortgage is a land transaction. This is made worse by the additional 3% stamp duty rate; care therefore needs to be taken here.

Transfer rental income to a spouse

If an individual’s spouse or civil partner is a basic rate taxpayer, they could transfer part or all of the property to them. This will then mitigate the impact of the mortgage interest restriction, as their tax liability is covered by the basic rate tax reducer.

A declaration of trust and potentially also a HMRC form need to be completed in order to effect the change.

Change of use of the rental property

If the property was changed from a normal residential let to a commercial property, a holiday let or to serviced accommodation, the effect of the mortgage interest restriction can be mitigated, as the restriction only applies to residential properties.

Transfer property into a limited company

The mortgage interest restriction only applies to rental properties held by individuals, not to those held by companies.

An option therefore is to transfer the properties into a company, which also benefit from lower tax rates (corporation tax is currently at 19% on profits). Please note, however, that there are stamp duty and capital gains tax implications of doing so.

There are ways of getting around these completely legally, but this does involve significant forward planning.

Other tax planning

Whilst not strictly a direct mitigation of the mortgage interest restriction, there are a number of other steps that can be taken to reduce individuals’ income tax, capital gains tax and inheritance tax liabilities and generally maximise their tax efficiency. These can include (but are not limited to):

  • Pension contributions

  • Gift Aid donations and other gifts to charity

  • Use of trusts

  • Tax efficient investments (ISAs, VCTs, EIS, SEIS etc.)

Contact Us

Please contact us to find out how the above applies in your circumstances and how you can reduce your tax liabilities, and maximise your tax efficiency.

Please note that the above is for general information only and does not constitute financial or tax advice. You should not rely on this information to make or refrain from making any decisions. You should always obtain independent professional advice in respect of your own situation.