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8:42 AM, 24th October 2017, About 7 years ago 39
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The following article is credited to Ross Martin, a firm which provides “practical tax resources for accountants and advisers” and has been copied verbatim from their website.
HMRC appears to have changed its long held views on the availability of tax relief on interest charged on new borrowings by property business owners who remortgage their property to withdraw capital from their business.
If this is a genuine change it may well impact on thousands of buy-to-let owners.
It is unclear is this is a policy change or an accidental error during the re-write of their Property Income manual (PIM) following the April 2017 Restrictions on Mortgage Interest Relief.
Historically, the rules, and examples, have regarded withdrawal of capital as being for the purposes of the trade since rental income became subject to the same accounting principles as trading businesses (2005/06). This was covered by the trade press in 2005. ICAEW guidance still reflects the position as it was understood prior to HMRC’s changes
HMRC’s old PIM guidance
HMRC’s previous PIM guidance to landlords who wish to remortgage their letting property was as follows:
HMRC guidance @ 31/12/2016 (it is unclear when this was changed)
|
Using HMRC’s old guidance, and assuming that you always withdrew all your rental profits as drawings, the balance sheet would be as follows:
| 3 years ago
£ |
Today
£ |
|
| Property original cost | 120,000 | |
| Property revalued | 150,000 | |
| Mortgage | (90,000) | |
| Mortgage | (115,000) | |
| Net assets | 30,000 | 35,000 |
| Represented by: | ||
| Owners’ capital account B/f | 30,000 | 30,000 |
| Revaluation reserve | 30,000 | |
| Less: capital withdrawn | (25,000) | |
| Total | 30,000 | 35,000 |
If you increased the mortgage to £125,000, your balance sheet would be:
| 3 years ago
£ |
Today
£ |
|
| Property original cost | 120,000 | |
| Property revalued | 150,000 | |
| Mortgage | (90,000) | |
| Mortgage | (125,000) | |
| Net assets | 30,000 | 25,000 |
| Represented by: | ||
| Owners’ capital account b/f | 30,000 | 30,000 |
| Revaluation reserve | 30,000 | |
| Less: capital withdrawn | (35,000) | |
| Total | 30,000 | 25,000 |
HMRC’s New Property Income guidance
| HMRC Property income @ ? 2017
If you increase your mortgage loan on your buy-to-let property you may be able to treat interest on the additional loan as a revenue expense, as long as the additional loan is wholly and exclusively for the purposes of the letting business. Interest on any additional borrowing above the capital value of the property when it was brought into your letting business isn’t tax deductible. |
If we take the old example and combine it with the new guidance, the additional interest charged on the increased borrowing of £35,000 would only be tax deductible if the funds from the new loan are used wholly and exclusively for the purposes of the letting business.
When and why?
HMRC appears to have changed its views as part of the re-write of its Property income manuals following the Restriction in Mortgage Interest Relief (subscriber version) rules that apply from 6 April 2017.
The updates section of the Property Income Manual fails to note when the changes were made.
There are no changes to tax relief for companies, loan interest relief for corporates remains is via the Loan Relationship Rules.
Confusingly, HMRC’s Business Income Manual (para BIM45700) provides a slightly different version of the rules.
| HMRC BIM45700 example 2 (18/10/2017)
A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business. There will, though, be an interest restriction if the proprietor’s capital account becomes overdrawn. Example 2 Mr A owns a flat in central London, which he bought ten years ago for £125,000. He has a mortgage of £80,000 on the property. He has been offered a job in Holland and is moving there to live and work. He intends to come back to the UK at some time. He decides to keep his flat and rent it out while he is away. His London flat now has a market value of £375,000. He renegotiates his mortgage on the flat to convert it to a buy to let mortgage and borrows a further £125,000. He withdraws the £125,000, which he then uses to buy a flat in Rotterdam. Although he has withdrawn capital from the business, the interest on the mortgage loan is allowable in full because it is funding the transfer of the property to the business at its open market value at the time the business started. The capital account is not overdrawn. The opening balance sheet of his rental business shows:
The balance sheet at the end of Year 1 shows:
|
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What does the legislation say?
Tax relief for business interest is given by s34 ITTOIA 2005, the rules apply for letting business, however since April 6 2017, there is a restriction in relief for higher earners.
S34 Expenses not wholly and exclusively for trade and unconnected losses
(1) In calculating the profits of a trade, no deduction is allowed for—
(a) expenses not incurred wholly and exclusively for the purposes of the trade, or
(b) losses not connected with or arising out of the trade.
(2) If an expense is incurred for more than one purpose, this section does not prohibit a deduction for any identifiable part or identifiable proportion of the expense which is incurred wholly and exclusively for the purposes of the trade.
Business income example v old property income example
The BIM example illustrates the withdrawal of capital before the rental business commences.
The old PIM example showed withdrawal of capital whilst the rental business was continuing.
EDITORS NOTE
It is very naughty that they have changed the wording of their internal manuals without any corresponding change in legislation, particularly as they have not dated the change. I have put the text highlighting the ambiguity in regards to the change in bold, red italics below.
HMRC Property income @ ? 2017
If you increase your mortgage loan on your buy-to-let property you may be able to treat interest on the additional loan as a revenue expense, as long as the additional loan is wholly and exclusively for the purposes of the letting business.
Interest on any additional borrowing above the capital value of the property when it was brought into your letting business isn’t tax deductible.
The question now is; what does “as long as the additional loan is wholly and exclusively for the purposes of the letting business”.
Show Book a Tax Planning ConsultationIt appears the latest update to HMRC’s manual which has caused confusion is indeed mistake and will hopefully be rectified in due course. HMRC also have Guidance Notes HERE which includes a section which reads as follows:
If you increase your mortgage loan on your buy-to-let property you may be able to treat interest on the additional loan as a revenue expense, as long as the additional loan is wholly and exclusively for the purposes of the letting business.
Interest on any additional borrowing above the capital value of the property when it was brought into your letting business isn’t tax deductible.
If the mortgage is for a residential property then the restrictions on interest from April 2017 will apply.
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H B
13:23 PM, 28th October 2017, About 7 years ago
Reply to the comment left by Mark Alexander at 27/10/2017 - 12:13
The statements are not so much ambiguous as potentially contradictory - HMRC can point to clear guidance that an increased mortgage will not be tax deductible and ignore what else it has said.
Again, this is a clear attack on our business tax principles that interest should be tax deductible and would frankly make a long-term plan to grow a property portfolio from a single property effectively non-viable, especially once other draconian landlord taxes are thrown in.
The war against the providers of housing continues...
Mark Alexander - Founder of Property118
13:34 PM, 28th October 2017, About 7 years ago
Reply to the comment left by H B at 28/10/2017 - 13:23
The question remains; is HMRC's guidance misguided? I think it is because the legislation upon which their amended guidance is based has not changed.
Simon Lever - Chartered Accountant helping clients get the best returns from their properties
10:15 AM, 29th October 2017, About 7 years ago
Please remember that HMRC's manuals are only their interpretation of the law and are not in themselves the law.
This change in interpretation will no doubt be tested at tribunal in the future.
However until this happens landlords who remortgage will be unsure if the additional interest will be allowable.
Where you remortgage to finance the creation of a company and then transfer the property portfolio to the company it is not clear if this would be considered to be for the “purposes of the trade”. There are arguments both ways and professional advice will need to be sought in each individual case.
Mark Hunt
10:43 AM, 29th October 2017, About 7 years ago
Mark,
I notice in your worked example above you have a "revaluation reserve" line in your table. This revaluation reserve does not form part of the landlord's capital account and therefore interest charged on any borrowings against it cannot be offset against income tax. The reason for this is that:
"A revaluation of business assets (for example property or goodwill) in advance of disposal is an example of unrealised profit and should therefore be disregarded [from the capital balance]"
This has always been the case. You can find this stated clearly here:
https://www.gov.uk/hmrc-internal-manuals/business-income-manual/bim45710
Maybe I'm misreading your worked example but it kind of implied to me that you were using equity gained from a revaluation to add to your capital account to borrow against? Apologies if I misread this. (Obviously you can borrow against this increased value, but you cannot offset the interest of any loans against it)
The implication is that in the below situation:
1. Landlord starts out by purchasing 'House A' valued at £120k using a self-funded £30k deposit and £90k IO mortgage.
2. 'House A' is revalued at £150k at some point in the future. The landlord has only been paying off the interest on the mortgage so although they now have £60k equity in 'House A', their capital balance remains £30k as the £30k arising from a revaluation of the house does not contribute to the capital balance (it is classed by HMRC as an unrealised profit, as per quote from HMRC).
3. Landlord now wishes to purchase 'House B' valued at £160k. To do this he requires a 25% deposit (£40k).
4. If the landlord generates this new deposit by increasing the mortgage on 'House A' from £90k to £130k, then he can only offset the interest associated with the first £30k of the additional money borrowed by re-mortgaging 'House A' as his capital account will now be overdrawn to the tune of £10k.
5. If the landlord wants to avoid his capital account becoming withdrawn he must introduce an additional £10k of capital into his portfolio.
I have spoken to many landlords using IO mortgages that seem to think that they can offset the mortgage interest arising from money borrowed against the rise in value of their properties. I tell them that they cannot. They insist to me that they can. I'm not a qualified tax advisor, so I usually stop the conversation at that point. They will find out in due course. Unfortunately now that S24 is in force HMRC have more to gain by looking closely at his.
Add to this, the few landlords I have met that have used the withdrawn equity to fund 'lifestyle' purchases (holidays, cars, improvements for their personal homes etc.) and continue to offset the mortgage interest against income, and I think this is going to become a major headache from next year :/
Mark Hunt
11:11 AM, 29th October 2017, About 7 years ago
Reply to the comment left by H B at 28/10/2017 - 13:23
Hi HB,
Provided that your capital account is not over-drawn, and that you have been using the money borrowed to grow your portfolio, then you have always been able to claim tax relief on interest and can continue to do so (subject to S24 amendments going forward).
The problems only arise where either a) you have allowed your capital account to become withdrawn, by funding deposits from borrowing more than the amount of money you have put into the portfolio through your own earnings and b) you have used the funds acquired by re-mortgaging for activities other than growing your business (i.e. lifestyle choices such as paying for improvements to your private residence, funding children's education, holidays etc..).
So long as you have done neither of the above, you should be fine (notwithstanding the impact of S24 of course!)
Mark Alexander - Founder of Property118
11:48 AM, 29th October 2017, About 7 years ago
Reply to the comment left by Mark Hunt at 29/10/2017 - 10:43
Please bear in mind that the article was copied verbatim from the Ross Martin blog and I seem to recall seeing the worked example they have referred to in HMRC’s own manuals.
That aside, I agree with most but not all of what you have said, and agree completely with Mark Hunts subsequent comment.
The only solution I’m aware of, which helps if incorporation is being considered, is for landlords with overdrawn capital accounts to become non-resident. This is because s162 TCGA 1992 can also be used alongside the non-resident CGT rules which effectively creates a new base cost value as of April 2015. I’ve provided a worked example of that particular scenario in our main Tax section under Case stuidies (top right of the page if your working from a decent sized laptop or desktop, or scroll down the page if you’re using a mobile device.
Link https://www.property118.com/tax/
Mark Alexander - Founder of Property118
11:54 AM, 29th October 2017, About 7 years ago
Reply to the comment left by Mark Hunt at 29/10/2017 - 10:43
Sorry, one further point. In your example, the landlords capital account would not be overdrawn. It would still be £30,000 in credit because the whole £150,000 of additional borrowed money will be matched with the acquisition of an asset of equal value.
Mark Hunt
12:22 PM, 29th October 2017, About 7 years ago
Reply to the comment left by Mark Alexander at 29/10/2017 - 11:54
Apologies, that is correct - it will be withdrawn by £10k until the purchase of House B is complete. Once complete the capital balance will return to £30k. But, the interest from the additional £10k above the balance of the landlord's capital that was loaned by re-mortgaging House A cannot be offset against rental income.
Mark Alexander - Founder of Property118
12:58 PM, 29th October 2017, About 7 years ago
Reply to the comment left by Mark Hunt at 29/10/2017 - 12:22
I disagree on your final point. The restriction is based on the aggregated amount, i.e. providing the capital account is not overdrawn the interest relief is unrestricted (save for the section 24 restrictions).
Restrictions apply as a whole to a property portfolio, not on a property by property basis. Same principles apply to s162 incorporation relief
Mark Hunt
14:15 PM, 29th October 2017, About 7 years ago
Mark,
Assuming you are using the reasoning below?
1. You pulled your £30k Capital out of House A and replaced it with mortgage debt, at the same time taking an additional £10k mortgage debt against the equity in the house. You also rolled the original £90k mortgage - thus you have £130k mortgage debt on House A. The bank will allow you do this because it recognises the £30k equity growth and allows you to borrow against it.
2. You purchased House B using the £30k equity + £10k mortgage debt from House A plus an additional mortgage of £120k
£130k+£120k = £250k mortgage debt
£120k+£160k = £280k original value property
Leaves your £30k original Capital