Buying a second property via an interest-only buy-to-let mortgage used to come with a level of tax relief that made it considerably more profitable for high earners to be landlords, but changes that came in April 2017 have changed all that, and the old mortgage tax relief system is on its way out, replaced with a mortgage interest tax relief credit system that came into full effect in 2020.
So, what is the BLT Mortgage Tax Relief System now and how does it change from what used to be?
When you pay tax on your rental income (new system from 2020)
Private landlords must declare the money brought in from rental as income for income tax. This has two main effects:
- Their income crosses a band threshold, pushing them into a higher tax bracket
- They have to pay income tax on the rental income
John has a buy-to-let mortgage on his property that he rents out at £1,100 per month. The mortgage costs him a flat £500 per month.
From April 2020, John will have to declare that full £1,100 as income, totalling £13,200 per year. As John earns £45,000 in his normal job, so this income pushes him slightly into the higher rate band of tax. £8,200 will be taxed at 40% (totalling £3,280) while the first £5,000 will be taxed at 20% (£1,000).
The total tax John will pay on his rental earnings is £4,280.
However, the new system also returns a tax credit of 20% on the total mortgage interest paid. In this case, that’s £1,200 that will be credited to John.
Once John’s mortgage and tax are accounted for and his credit applied, his profit on his rental property (not considering periods of no occupancy or maintenance and repair) will be £4,120 for the year.
How the old system used to work
Prior to 2017, John would have been charged income tax only on the profit for his rental – that is the rental amount with the mortgage accounted for. In this case, he would have been taxed only on £5,200 (£13,200 minus £6,000 in mortgage payments). This would have been a total of £1,080 and would have left him £6,120 in net profit for the year - £2,000 less paid in tax.
The interim system – 2019 to 2020 year
Somewhat confusingly, in the years between 2017 and 2020, the changeover has been gradual. The current tax year is the last interim year of 2019/20.
For this single year, 25% of the income counts as the old system, with the remaining 75% taking the new rules.
For John, this would mean that one quarter of his taxable income is £1,800 (calculated as £3,300 - £1,500), and the remaining £9,900 is added in full. His total value for income tax purposes is £11,700.
This would result in an income tax bill on the rental portion of John’s income to be: £3,680.
He would also receive a 20% credit on the £4,500 of mortgage interest from the 75% portion, providing him a rebate of £900.
Under this interim system, John’s total net profit for the year after taxes, paying the mortgage, and receiving the credit would be: £4,420 - £300 better off than next year.
Being a business – lowering your tax thought incorporation
The new mortgage interest tax relief rules only apply to private landlords. For businesses letting out property, tax is paid only on the profits the business makes, and thus the mortgage value is deducted prior to the tax calculation.
In simple terms, this means that businesses effectively use the old system and not the new one.
For many, this is a strong reason to change from being a private landlord to an incorporated business – and it’s not the only tax advantage of doing so, as your accountant could explain.
However, it’s important to understand that it would require you to transfer any currently owned properties into the business and that will incur a stamp duty payment which could easily wipe out any gains you might get from the superior tax relief.
For many, it’s best to accept the new system for any currently owned properties and set up a limited company for future expansion.
Here at The Mortgage Hut we have advisors who can help you with your BTL and landlord enquiries, as well as being able to find you the finest interest-only mortgages with staggeringly low rates. Fill in our simple form or give us a call today for more information.