Insights

January can be a time when a small number of clients can get an unwelcome surprise, because their tax bills are slightly higher than expected. This highlights the importance of having regular tax planning reviews to ensure that one’s financial affairs are structured in the most tax efficient way possible. This year, one specific situation has prompted us to write a blog about property and tax relief. In doing so, we hope to ensure all our clients understand how tax relief for mortgages work and which mortgages qualify.

For investors owning rental property, it is always most tax efficient to take out an interest only mortgage. This is because it is possible to deduct the interest payments from the rental income received; ie tax relief is available on the whole of the mortgage cost. Any capital paid off on the mortgage amount does not qualify for tax relief

In contrast, if the mortgage is a repayment mortgage, part of the repayment is interest and part is a repayment of capital and therefore only the interest element is tax deductible.

Interest only for buy-to-let

Most buy to let investors prefer interest only mortgages, but in the current climate these are not always possible to obtain. It can also be the case that if the property being let is commercial property, rather than residential property, the lender won’t offer anything but a repayment mortgage, because the risks associated with this type of property are greater.

If you let a property and find yourself in this predicament, you should be aware of the proportions of interest and capital being repaid. If the amount of capital being repaid is high, as it would be, for instance, with a mortgage nearing the end of its term, this may result in a negative cash flow. In this situation, any capital repaid through the mortgage cannot be deducted from income for tax purposes.

Avoid a negative cash flow situation

Consider the following example to illustrate this point:

Mr Jones receives £3000 a month from rental income on his house, which is on a repayment mortgage.

His mortgage payments are £2000 a month and he has almost reached the end of his mortgage timeframe. As a result his payment is made up of £1500 capital and £500 interest.

Only the £500 interest payment is tax deductible and therefore Mr Jones’ taxable income is £2,500 per month. If he is a higher rate tax payer then the tax liability on his rental profit will be £1,000 per month, which means that his rental income of £3,000 per month is fully utilised by paying the mortgage and his tax bill. In certain circumstances the position can be worse; it is possible for the mortgage and the tax liability to exceed the rental income.

In our example here, as the mortgage term approaches, Mr Jones’ tax liability progressively worsens because more capital on his loan is repaid and the amount of interest reduces correspondingly.

In the end, Mr Jones potentially faces a negative cash flow situation because the rental income from his property is equal to his mortgage repayments, for which he receives no tax relief. On top of this he also has to pay tax on the rental profit that he is making.

Take specialist advice

As tax advisers we are not authorised to offer clients financial advice however as tax specialists we advise all clients with rental properties – whether residential or commercial - to be aware of the impact their mortgage arrangements have on their tax liability. For advice on tax planning for property investments please contact Lesley Stalker by emailing las@rjp.co.uk.