Three major changes on the horizon for landlords are likely to significantly affect the returns they can expect to see from their properties. Graham Poles outlines the changes and their potential impact

The buy-to-let market has been reasonably buoyant over the past few years, picking itself up following the recession. With modest growth in capital values in many parts of the country, a growing number of investors have started diversifying into this market. However, recent changes in the taxation of the buy-to-let market could have a major impact on the returns investors can expect.

Boxed in


This article looks in particular at the changes proposed in the 2015 summer budget, but also at the changes to the Mortgage Credit Directive, which comes into force from April 2016.

1 Mortgage interest tax relief

The summer budget contained two changes to the way property profits are taxed, and from what I understand, neither of these changes was expected by the industry. The first and most significant was that to mortgage interest tax relief.

The current position is that an investor who borrows funds to purchase a property for letting can claim the interest element of their loan against their profits from the buy-to-let. The interest is deducted in their profit-and-loss account which is, of course, logical and follows the standard method of accounting for finance costs.

The investor is then subject to tax, at their marginal rate, on these profits, which depends on the profits made and any other taxable income they have. For those who have taxable income under £10,600, there will be no further tax due on this income. For investors with income in excess of this figure, the tax rate climbs to 20% for income up to £42,385. Past that, it climbs again to 40%, before it hits the additional rate of tax of 45% for income over £150,000.

The chancellor wants to remove this deduction of loan interest from the rental income, and replace it, over a number of years, with a tax credit of 20% given in the investor’s tax computation. On the face of it, this doesn’t seem that radical, but it could, in fact, have a significant impact on the actual proportion of tax payable. Those worst affected will see the tax they pay increase significantly, perhaps by enough to wipe out their profits entirely, depending upon the gearing on the property.

The policy document states that the government wants to restrict higher rate taxpayers from receiving interest relief at higher rates. Each year, a reducing percentage of the finance cost will be allowed in full, and the balance will be relieved with a tax credit. The tax credit will be calculated as 20% of the lower of the:

  • finance costs not deducted from income in the tax year (25% for 2017 to 2018, 50% for 2018 to 2019, 75% for 2019 to 2020, and 100% thereafter);
  • profits of the property business in the tax year; and
  • total income (excluding savings income and dividend income) that exceeds the personal allowance and blind person’s allowance in the tax year.

If there are excess finance costs, then these can be carried forward to future years if the tax reduction has been limited to 20% of the profits of the property business in the tax year. This small concession does not change the fact that these changes will have a significant impact on those taxpayers affected.

If we take a typical rental portfolio generating income of, say, £25,000 per annum with no other associated costs other than loan interest, which is £15,000, this leaves a profit subject to tax of £10,000. Currently, assuming the investor has other income which wipes out their personal allowance and pushes them into higher rates of tax at 40%, which is not an uncommon situation in my experience, this would see the profit of £10,000 generating a tax bill of £4,000.

However, once these changes are fully effective, the position will change so that the income of £25,000 will now be the taxable profit. The tax bill at 40% will now increase to £10,000, less a tax credit of £3,000, giving an overall tax bill of £7,000 – an increase of £3,000 or 75% over previous periods.

The problem can be exacerbated where the taxpayer is close to the next tax band. Where someone is currently taxed at 20%, they may, at first blush, believe that these changes do not affect them. Given that the tax relief will also be 20%, you would expect them to be no worse off. However, if we take the above example and assume the taxpayer had other income of £30,000 before their personal allowance is applied, we can see this is not the case.

Currently, this level of income will extinguish their personal allowance, and the profits from the rental property at £10,000 would see their total income come in just below the higher rate tax threshold. This would mean that their tax liability would be £2,000, being 20% of the profits.

However, when the changes come into force (assuming allowances remain the same), the full £25,000 will be taxable as income – pushing this investor into higher rates of tax, with income now of £55,000. Therefore, their tax on the same business will increase to £7,523, less a tax credit of £3,000, meaning an increase in tax of £2,523 or 126%.

The position is made worse the higher the gearing, with tax increases being around 150% in the worst cases. Obviously, for the investor who doesn’t have any borrowing, the change will have no impact, but for many investors, this will seriously erode their retirement fund. It will perhaps push some to sell if they cannot balance the changes with much better capital growth. What makes this position worse is that investors subject to higher rates of tax, who have loan interest above 75% of their rental income, will see their entire profits wiped out by this increased tax bill. This level falls to 68% for additional rate taxpayers.

These changes are being phased in from April 2017, and will be fully implemented by 2020. The phasing of the changes is set out in the table opposite.

Property investors clearly need to examine their portfolios and decide how the changes will affect their investments. The extended period, before full effect, is meant to allow time for investors to restructure their property portfolios to take account of the changes.

The changes will not affect those operating their business through a limited company, where finance costs will remain allowable. Could this mean that taxpayers should consider changing their business structure? The answer to that will rest with the practicalities of the investor reorganising their debt through a corporate structure. The banks will certainly not be looking to do this without examining the interest rates applicable, which may see the finance cost increase – although it is possible, of course, that they may not.

The other consideration is stamp duty land tax, which will be due if a taxpayer transfers their property into the limited company. If there is a property partnership, then it may be possible to make the transfer while claiming the partnership exemption contained in schedule 15 to the Finance Act 2003. It should be possible to avoid the capital gains tax on the transfer of the properties by holding over the gain into the shares in the company, which also allows the company to then sell properties without suffering the gains. However, the gain is not lost, but simply deferred against the value of the shares, so if the company is sold or liquidated, then the gain will still be due.

One important point to note is that the changes do not affect those who have invested in furnished holiday lettings, which continue to be regarded as a trade. This important difference might see at least some of UK rental properties, subject to their location of course, being shifted to furnished holiday lettings, so they can continue to benefit from relief on finance costs.

2 Wear and tear allowance

The second change introduced by the chancellor in the summer budget was the removal of the wear and tear allowance from April 2016. This was a standard allowance that could be claimed, by those letting property, as a deduction against their taxable income, to cover the costs of furnishings in the property. This avoided the need for those businesses to use the renewals basis, which require the taxpayer to claim the cost of the replacement item when it comes to the end of its useful life.

The main advantage of the wear and tear allowance was the simplicity with which it could be calculated. The allowance is 10% of the ‘relevant rental amount’, which was defined as:

  • the receipts from furnished residential lettings recognised in arriving at the profits for the period, less
  • any expenses that would normally be borne by the tenant.

The items that were covered under the second bullet point would include the utility bills (gas, water, electricity) and council tax. The relief only applied to net rents from fully furnished lettings. For those landlords who had unfurnished lettings, the rules were tightened from April 2013, potentially leaving them with no way to claim for some replacement items that were included in their properties.

What is being proposed is a new relief called ‘replacement furniture relief’. This will act in the same way as the renewals basis, but the advantage of this new relief is that it will apply across both unfurnished and furnished lettings. It is worth noting that commercial lettings and furnished holiday lettings will continue to attract relief for this expenditure under the normal capital allowances rules.

The consultation on this new relief closed recently, so there may be changes, depending upon the feedback that the government receives, but as it stands, no relief will be given for the original cost of purchasing the furniture, but when it requires replacement, the full cost of the replacement will be deductible.

However, it’s not quite as straightforward as it first appears, because if the replacement represents an improvement over the original, then this element of improvement must be excluded. The example given is of a landlord replacing a washing machine with a washer-dryer, which is an improvement. If the washer-dryer cost £600, and the cost of buying a new washing machine like the old one would have been £400, then the replacement furniture relief will be £400 (£600, less the £200 that represents the difference in cost between a washing machine and the washer-dryer). This is, of course, logical, but it will make matters more complex, as the landlord will need to assess whether the new item is an improvement, and if so, what a like-for-like item would have cost.

Loan interest relief

Loan interest relief

Also, the relief does not extend to fixtures which are an integral part of the building, such as baths, washbasins, toilets, boilers and fitted kitchen units; here, any replacement would be deductible as a repair.

Interestingly, the impact document that accompanies the consultation states: ‘This change will create an additional administrative burden for individual landlords who currently claim the wear and tear allowance as they will now need to keep a record of their actual expenditure. This is estimated to be around 750,000 individuals (and households), and the impact on affected individuals (and households) is anticipated to be negligible given that they currently keep records of other expenses such as repair costs.’ In my experience, these changes, while appearing innocuous on the surface, will mean greater time and costs for landlords, especially during the transitional year.

The government will certainly feel that the change is worthwhile, as the impact note reports that from 2016/17, it will see a positive revenue flow to the Exchequer of £205m. The removal of this simple allowance will undoubtedly cause some issues for landlords, who will need to speak to their professional adviser about which relief they have claimed in the past and how future replacements will affect their taxable profits.

In my experience, these changes, while appearing innocuous on the surface, will mean greater time and costs for landlords, especially during the transitional year

3 The Mortgage Credit Directive

Finally, the Mortgage Credit Directive (MCD), which will come into force on 21 March 2016, introduces an EU-wide framework of conduct rules for mortgage firms. These new rules, contained in the Mortgage Credit Directive Order 2015, will be introduced by the regulator, the Financial Conduct Authority, which has now been given powers to register and supervise firms that offer consumer buy-to-let mortgages (CBTL).

The Mortgage Credit Directive Order 2015 defines a CBTL mortgage contract as a mortgage contract which is not entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower.

The legislation then goes on to set out a series of circumstances that would constitute a buy-to-let customer acting for the purposes of business, which takes them outside this framework. These include situations where a customer:

  • uses the mortgage to purchase a property with the intention of
  • renting it out;
  • has previously purchased the property with the intention of letting it out and neither the customer nor a relative has inhabited it; or
  • already owns another property that has been let out on the basis of a rental agreement.

Furthermore, the changes also enable a mortgage firm to presume that a borrower is acting as a business if the agreement that the consumer signs includes a declaration from them that they are acting as a business and understand that they are forgoing protections offered by the legislation to consumers.

There are lots of changes coming in this sector, and landlords need to understand what impact each of these will have on their business. In particular, the relief for loan interest changes will mean that the return on investment for many landlords will fall significantly.