Funding the Buy-to-LetThe banking crisis has hit borrowers hard and those with buy-to-let mortgages may find themselves reviewing their financing options. The need to review the position may be triggered by the end of a fixed rate loan and the accompanying hike to the lender’s standard variable rate. Now is not a good time to be agreeing a mortgage deal, particularly one on a buy-to-let property. Buy-to-let mortgages typically attract higher fees and higher interest rates than standard homeowner loans.
Rising mortgage costs may mean that the rent no longer covers the mortgage payments. However, the falling property market means that now is also not a good time to sell. This means that many buy-to-let investors have some difficult decisions to make.
For the small time investor with sufficient equity in his or her main home, one option may be to release equity from the main home and use this to pay off the buy-to-let mortgage. A loan secured on the borrower’s residential home will generally attract a lower rate of interest and often lower arrangement fees than a specific buy-to-let mortgage secured on the rental property.
While this may save interest, is this effective from a tax viewpoint and will the borrower still be able to claim a deduction against the mortgage interest if the let property is now mortgage-free?
Deductibility of Expenses
The general rule is that for an expense to be deductible, that expense must be wholly and exclusively for business purposes and applied equally for the purposes of computing the profits of a property rental business. This rule applies equally to the deductibility of interest payments as it does to other expenses.
Interest payable on loans to buy land or property that is used in a property rental business is deductible in computing the profits of that business. Interest on loans to fund repairs, improvements or alterations is similarly deductible.
The deduction is only given to the extent that the borrowings are used for the purpose of the property rental business. Care should be taken here as where the borrowings are used for both business and non-business purposes, it may be difficult to determine the extent to which the interest is deductible.
The fact that a property is empty for part of the year will not necessarily restrict the interest deduction provided that the property was available for letting throughout and the landlord was genuinely trying to let the property. However, a deduction would not be permitted in respect of period for which the property was neither let nor available for letting.
Release of Equity from Main Home
As noted above, in certain circumstances it may be cost effective to release equity from a residential home to purchase a buy-to-let property or refinance the property at the end of a fixed rate mortgage deal.
The fact that the borrowings are not secured on the buy-to-let property does not inhibit the interest deduction. Interest remains allowable to the extent that it is incurred wholly and exclusively for the business purposes and this is the test that must be applied. If this test is met, the interest is deductible. If this test is not met, the interest is not deductible. It is as simple as that.
In an equity release situation, the interest remains deductible provided that the equity released is used for the purpose of the property income business. If the equity released from the main home is used to purchase a buy to let property or to refinance an existing property, the interest is deductible. This is illustrated by the following examples.
Lee purchased his home ten years ago for £150,000. The property is now worth £500,000. He has a mortgage of £50,000 on the property.
He wishes to take advantage of falling property prices and buy and property to let out. He releases £100,000 of equity from his main home to fund the purchase and buys a property for £100,000, which he subsequently lets out.
As a result of the equity release, he has borrowings secured on his residential home of £150,000. Of this, £100,000 is used for the purposes of the property rental income. The interest on the £100,000 is deductible. The remaining £50,000 of borrowings is for personal purposes and the associated interest is not deductible.
Mandy purchased a property to let out in 2004 for a cost of £140,000. She funded the property with a buy-to-let mortgage of £100,000 and savings of £40,000. The buy-to let mortgage was an interest only mortgage for a fixed term. The fixed interest rate came to an end in June 2008, after which interest was payable at the lender’s variable rate applicable to buy-to-let mortgages. The property is now worth £160,000.
Due to the increase in the interest rates at the end of the fixed interest period, Mandy reviews her financing options. She decides that releasing equity from her main home is the most cost effective option.
She purchased her main home in 1999 at a cost of £200,000. She has a mortgage of £70,000 on the property. The property is currently worth £475,000. She agrees with her mortgage lender to release equity of £100,000, which she uses to repay the buy the let mortgage at the end of the end of the fixed rate term.
Although the buy-to-let mortgage has been redeemed, the money borrowed to redeem this mortgage was borrowed for a business purpose, i.e. the finance the buy-to-let property. Consequently, interest on the additional equity release is deductible.
Where this approach is taken, the deductibility of the borrowings is not limited to the amount of the loan previously outstanding on the buy to let property, but to the value of the buy-to-let property when it was first let.
In example 2 above, Mandy’s buy-to-let property had a value of £140,000 when first let. Interest on borrowings up to this limit is deductible, regardless of the financing route taken.
As the buy-to-let property is now worth £160,000, Mandy could have decided instead to take out a new mortgage of £150,000 secured against that property and release some of the equity to buy a new car. However, only £140,000 of the borrowings is for the purpose of the business as the property was worth £140,000 when first let. The remaining £10,000 is personal borrowings and the associated interest is not deductible.
The same principle applies if Mandy releases equity from her own home to refinance the buy-to-let and to release equity from it. The interest is deductible on borrowings to a limit of £140,000 – the value of the property when first let. It does not matter that the outstanding mortgage on the buy-to-let property was only £100,000. Mandy initially needed funding of £140,000 to buy the property in order to let it out.
Where the loan is on a repayment basis, it is important that only the interest element of the mortgage repayments is deducted from the rental income, rather than the full amount. The capital repayment element is not deductible. The lender should provide the split if this is not shown on the mortgage statement.
Under an offset mortgage, the borrower’s savings are set against the loan and interest charged on the net amount. Interest on an offset mortgage is deductible to the extent that the borrowings relate to the buy-to-let business.
In the current climate, many lenders are charging high mortgage arrangement fees. These fees are deductible provided that they relate to business borrowings. Likewise, any associated legal or survey fees are similarly deductible.
The current banking crisis and the lack of cheap and easy credit may force buy-to-let investors to consider alternative financing options. Whatever route is taken, the same basic rule applies and interest is deductible to the extent that it relates to the business, regardless of whether the loan is secured on the let property or not.