The way in which mortgage interest relief is calculated for rental income purposes began changing with effect from 6 April 2017.
The 2017/18 tax year was the first year where the changes were introduced to gradually restrict the income tax relief on mortgage interest payments to the basic rate of 20%.
The 2019/20 tax year is the final ‘phasing-in’ year in which the restriction of the mortgage interest needs to be calculated. 25% of the mortgage interest will be allowed as a deduction from rental income and the other 75% will be applied as a tax reducer at the basic rate of 20%.
From the 2020/21 tax year onwards, no deduction will be allowed for mortgage interest in calculating the rental profits. The mortgage interest paid on a rental property will be applied as an income tax reducer.
The income tax reducer is only allowed against taxable rental profits. If there is a rental loss arising in the tax year, or if the rental profit is covered by the personal allowance, then the mortgage interest will be carried forward until such time as there are taxable rental profits.
The examples below show the impact of the mortgage interest changes:
Example 1 – 2019/20 Tax Year
Mr Baggins received a salary of £50,000 and gross rental income of £15,000. He paid mortgage interest of £6,000 and had other rental expenses of £2,000.
25% of the mortgage interest (£1,500) is deducted from the rental income, along with the other rental expenses of £2,000, giving a rental profit of £11,500. The rental profit is taxable at the higher rate of 40%. The income tax liability on the rental profit is £4,600 (£11,500 * 40%).
The remaining 75% of the mortgage interest (£4,500) is calculated as a tax reducer at the basic rate of 20%. The tax reducer of £900 is deducted from the income tax liability of £4,600 giving Mr Baggins a net income tax liability on his rental profits for the 2019/20 tax year of £3,700 (£4,600 – £900).
Example 2 – 2020/21 Tax Year
Mr Baggins’ income and expenses remained the same in 2020/21 as they were in 2019/20.
No mortgage interest is deducted from the rental income, only the other rental expenses of £2,000, giving a rental profit of £13,000 which is taxable at the higher rate of 40%. The income tax liability on the rental profit is £5,200 (£13,200 * 40%).
The whole of the mortgage interest (£6,000) is calculated as a tax reducer at the basic rate of 20%. The tax reducer of £1,200 is deducted from the income tax liability of £5,200 giving Mr Baggins a net income tax liability on his rental profits for the 2020/21 tax year of £4,000 (£5,200 – £1,200).
The changes to the mortgage interest relief will lead to a higher tax liability and will potentially have an impact on other areas, for example, the tapering of the personal allowance or the High-Income Child Benefit Tax Charge.
Here at Plus Accounting we will be very happy to help you with your rental property queries with our personal tax advisory and compliance services.
Author: Anthony Barron, Personal Tax Manager @ Plus Accounting
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Date Published: 10 September 2020