Every landlord should know paragraph 45700 of HMRC’s Business Income Manual (www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htm) almost by heart, because it describes a very powerful tax relief that, properly used, can greatly increase your disposable income by transferring your mortgage on your home (for which you cannot claim a tax deduction for interest paid) to mortgages on your buy to let portfolio, the interest on which is deductible against your rental income. This technique only works for individual landlords, not for limited companies, so it is an important point to consider when deciding whether to use a company for your letting business or not.
In order to understand how this works, we need to consider basic accounting principles. When you, as an individual, begin to let a property for the first time, you have “introduced capital” to your new business of property letting. The amount of capital introduced is the market value of the property at the time you begin to let it, minus any loans secured on that property.
If we take a simple case of inheriting a property and deciding to let it (so there are no loans involved at this stage), then if that property has a market value of £200,000 on the day you begin to let it, you have introduced capital of £200,000 to your new property business.
You are entitled to withdraw this capital from the business at any time without any tax consequences, and if the business has to borrow money to finance this withdrawal, then the cost of the interest on that loan is an allowable expense of the business. It does not matter what the money withdrawn is used for, because the purpose of the loan was to finance your withdrawal of capital you had previously introduced to the business.
If, therefore, you have a mortgage on your home of £150,000, and you raise a loan secured on the letting property of that amount and use it to pay off the mortgage on your home, you have just transformed the home mortgage into a business loan, and you can claim the interest on that loan against the letting income from the property.
In cases where you need to use a mortgage to buy a letting property, then the capital you introduced will have been the difference between the market value of the property when you first let it, and the amount of the loan used to buy it. Once the property has increased in value to the point where you could refinance and increase the loan to the market value when the property was first let, the surplus cash can be taken out of the business and used for any purpose you like – including paying off all or some of your home mortgage – with the interest still fully deductible against the income from the property business. If you have more than one letting property, all such properties (within the UK) are treated as one business, so the interest is deducted from the total of all the rents received.
If you have followed the explanation of the accounting treatment of the introduction of properties to the letting business, you will avoid the trap that catches some people – the limit on the loan that will qualify for tax relief on the interest is the market value of each property at the time it was first let. If you borrow more against a property than this amount, the tax relief on the loan will be restricted to the amount representing the loan up to that historic market value.
Of course in the real world things are more complicated than this, and in particular there may be repayment penalties on your home mortgage, and in general, interest rates on home mortgages tend to be lower than that on buy to let mortgages. It is nevertheless worth doing the sums in any case where you are a buy to let landlord, and you also have a mortgage on your home.
Practical Tip :
In some cases, this can be taken another stage further. If you decide to move home, bear in mind that if instead of selling your old home you let it, you can raise a loan secured on the old home and this loan will qualify for tax relief because the old property is now part of the letting business.