The change to mortgage interest relief was first announced in the 2015 emergency Budget, and at first it didn't seem to make a lot of sense. I was embarrassed that it took me a few days to get my head around it — although less so when it became clear that most media commentators (and indeed many accountants) weren't entirely sure what it meant either.
Since then it's become variously known as Section 24 (boring), The Alice In Wonderland Tax (don't quite get it) and The Tenant Tax (disingenguous) – but whatever you call it, a whole lot of people still don't quite understand how it works and what it means.
So, let's work this through…
The old rules – until April 2017
Up until April 2017, you could deduct your mortgage interest (plus associated costs like arrangement fees) along with all your other costs before determining your taxable profit.
So to take a simple example:
£10,000 rental income
£5,000 mortgage interest costs
£1,000 other costs
= £4,000 profit
You were then taxed on that profit at your marginal rate — so a basic rate (currently 20%) taxpayer would pay tax of £800, and a higher rate (currently 40%) taxpayer would pay £1,600.
(There's also an “additional rate” of 45% for incomes about £150,000, which I'm ignoring both here and in the spreadsheet for simplicity.)
The new rules
Ever since the new measures fully took effect in April 2020, you can no longer deduct mortgage interest costs from your taxable profits if the property is owned by an individual. (If the property is owned as a company, you continue under the old rules and none of this applies.)
Instead, everyone can claim a basic rate allowance for their finance costs — irrespective of their marginal rate.
So let's take the same figures as above and see how things have changed:
£10,000 rental income
[£5,000 mortgage interest costs – NOT DEDUCTED]
£1,000 other costs
= £9,000 profit
Yikes! A basic rate taxpayer would pay £1,800 tax on that new £9,000 profit, and a higher rate taxpayer would pay £3,600.
BUT WAIT…everyone gets to claim a basic rate deduction of 20% of that £5,000 mortgage interest cost. That's £1,000.
So the final position is…
Basic rate taxpayer:
20% tax on £9,000 profit = £1,800
Minus £1,000 deduction (20% of £5,000 interest cost)
= £800 tax to pay
Higher rate taxpayer:
40% tax on £9,000 profit = £3,600
Minus £1,000 deduction (20% of £5,000 interest cost)
= £2,600 tax to pay
So what's happened?
Two things.
Firstly, you'll notice that the basic rate taxpayer ends up paying exactly the same amount of tax under the new system: £800. The higher rate taxpayer, however, ends up paying £1,000 more. No bueno.
But this doesn't mean that the basic rate taxpayer is unaffected. Because the deduction is applied after calculating the taxable profit, everyone's “profit” has actually increased — from £4,000 to £9,000.
This means that people whose income (from property plus employment and any other sources) is below the higher rate threshold may end up getting pulled into the higher rate band as a result of their higher property “profits”.
What should you do about it?
In the immortal words of Douglas Adams, Don't Panic.
When this was first introduced, investors spoke about this as if it was game over for property investment. But the first thing to do is run the numbers for the “before” and “after” scenarios –you might be surprised by how little difference it makes in your situation (I was).
Investors have had quite a few years to acclimatise to the changes and make any adjustments needed, but if this is the first you're hearing about it you've got various options:
- Set up a company and sell your properties to it – although this will trigger CGT and Stamp Duty liabilities, and you'll need to remortgage
- Sell properties that are no longer profitable
- Attempt to cut costs to offset the extra tax you're paying
And if you don't own investment properties yet?
If you don't own properties yet but you're thinking about it, you might want to consider buying them in a limited company structure to swerve this whole business altogether.
This is something many, many investors are doing for new properties they buy, because it neatly sidesteps this whole issue: companies can continue to operate under the “old rules” and deduct their full interest costs.
Depending on your personal circumstances there might be other drawbacks to investing through a company, and it's something you should definitely take advice around before making a decision. I get into more detail in this post about the pros and cons of company ownership