Why a cut in the basic rate of tax could hurt landlords

The issue

Many landlords have felt somewhat shafted by tax legislation for a while now. The restriction of tax relief on finance costs has been fully in force for some years now and these rules mean that in many cases landlords face a tax liability on a non-profitable business. These rules restrict the rate at which tax relief can be claimed on finance costs to 20%, even though the rental income itself can be taxed at rates up to 45%. As interest rates continue to rise, the impact on landlords is getting harder to swallow.

Example

Dan is a landlord with a property portfolio worth £5m, with borrowings of £4m at an interest rate of 6%. The rental income that this portfolio yields is £300,000 and there are also £60,000 of various maintenance and administration costs. The way that the tax works here is that Dan is taxed on £240,000 (£300,000 less £60,000) and also receives a credit of £48,000 (20% of £240,000) in respect of the interest. His tax liability, ignoring the interest expense, comes out as £94,203 as follows:

• He gets no personal allowance because that has been tapered away
• £37,700 is taxable at 20%
• £87,440 is taxable at 40%
• £114,860 is taxable at 45%

After deducting the £48,000 credit from the above tax liability of £94,203, we get to a liability of £46,203. The true commercial profits of this rental business were, however, £300,000 less £60,000 less £240,000 or the grand sum of zero! Therefore, Dan has to find £46,203 a year to fund his unprofitable business.

Decrease in the basic rate of tax

The Conservative party has at various stages been mooting the idea of a cut in basic rate income tax from 20% to 18%. If they were to do that, then the above example would need to be amended as follows:

1. £754 decrease in the liability based on the decrease in the basic rate band.
2. £4,800 increase in the liability due to a lower interest credit.

Therefore a 2% decrease in the basic rate of tax for Dan could lead to a £4,046 tax hike on profits of nothing. That’s £50,249 that Dan has to find out of profits of zero. Talk about kicking a man when he’s down…..

Our view

Hopefully, in the above scenario, the interest restriction would be uncoupled from the basic rate of tax, although the Government do not exactly have a track record of keeping an eye out for landlords. Even if landlords do not end up being affected by a rate decrease, the above example does serve to show the miserable time that geared landlords are having in the midst of rising interest rates. Those who are not keeping their eyes on the tax ball may be in for a nasty shock when they calculate their tax liabilities.

The million-dollar question is what should they do now? One option is to throw in the towel and sell their properties. Alternatively, they could incorporate their properties into a company which does not suffer the interest restriction. This presents its own headaches in the form of potential capital gains tax and stamp duty land tax (SDLT) charges. Although there can be certain reliefs to these taxes (and in certain cases these reliefs will fully mitigate the tax), landlords should be wary of sharks circling them who promise them a low tax Nirvana, which may not be achievable in practice.

The weekly Tax Bites are not intended to constitute tax advice. The information provided in these articles is based on our understanding of current tax law; however, we do not represent or warrant the accuracy of the information contained therein, and any information provided may be incomplete or condensed. Furthermore, the suggestions contained within these articles are for discussion purposes only and should not be relied on. You should seek formal tax advice before proceeding with any of the suggestions contained in this document.