In what seems a long time ago now, the first edition of ‘Property Tax Insider’ contained an article entitled ‘Low interest rates - A problem for some.’ The article suggested a method of reducing rental profit by the offset of mortgage interest charged on a capital sum obtained via the release of equity in a property. This article revisits that suggestion in greater depth with particular reference to a ‘Buy to Let Portfolio’ of properties.
In the original article reference was made to a little-known section of the ‘Business Income Manual’ hidden on the Revenue’s website at http://www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htmUsing section BIM 45700
The relevance of the section is in the title: ‘BIM45700 - Specific deductions - interest: Withdrawal of capital from a business’
and confirms that where a proprietor of any business finances the capital of that business with a mortgage then the interest is allowable against the profit made. Should the owner subsequently withdraw some capital the interest remains allowable in full because the original reason for the mortgage being taken out remains; which was to fund the transfer of capital into the business at its open market value at the date that the business commenced. Renting out a property is deemed a ‘business’ in the Taxman’s eyes and as such the ‘capital’ investment is the property itself.
Thus as far as the Revenue are concerned the interest paid is allowable in full as a deduction against profit because they are more interested in the purpose of the original loan and not the assets against which the loan is actually secured. If, at a subsequent date the loan remains but some of the capital is withdrawn from the business (via the means of remortgage and withdrawing the increased equity) then tax relief is still allowed in full.
The first article explained the mechanics of remortgaging a rental property, releasing any equity that the property might hold and then using that capital amount for further investment. This investment may take the form of finance to purchase another property or even to reduce capital outstanding on a main residence - full tax relief on the gross interest paid will still be allowed.
There is one restriction - the amount of equity/ capital that is released must not be greater than the market value of the property when it was originally brought into the letting business. If the property had originally been bought for letting, then this amount would be the purchase cost of the property.
If the capital is being used to purchase a new main residence and it is the former main residence that is to be let, the amount of tax relief is restricted to the value of the former main residence on the first day that the property becomes tenanted.
Buy to Let Portfolio
When landlords own two or more properties, this is generally referred to as a property ‘portfolio’. Mortgage lenders have designed a product known as a ‘buy to let portfolio mortgage’ which uses the fact that BIM45700
exists. With this product the properties comprised in the property ‘portfolio’ are treated as being held within a single account. The individual properties may have separate mortgages with different interest rates charged but the value of such a ‘portfolio’ account is that it is treated as a single account regardless of the number of properties. The use of one portfolio is contained in one agreement; this means one direct debit mandate, one monthly payment and one mortgage statement for the entire buy to let mortgage / property portfolio.
Buy to Let Lending
Owners who intend to create a buy-to-let portfolio of properties and invest for the long term may wish to consider such products as it enables flexibility and can ensure that maximum tax relief is being achieved. The rental income and loan to value is averaged across the whole mortgage portfolio and this enables advantage to be taken of any excess rental income or equity in the whole business which can then be used to support the purchase of other properties for the portfolio. For example, if the value of six properties totals £2 million and the total of mortgages outstanding thereon is £1.7 million, there is a shortfall of £300,000 overall. This amount will not be the equity in any one property but the total amount of equity spread over the whole portfolio of properties. The £300,000 is the amount of credit available for further investment.
The availability of such a stream of credit enables an investor to make bids on the purchase of properties such that he will not have to apply for finance each time he wants to expand his portfolio. The newly purchased property is then added to the portfolio which, assuming an increase in property value will increase the credit facility once again. As well as additional equity, excess rental income can be invested also increasing the amount of credit available for further investment.
To enable an investor to take advantage of such a method of financing lenders usually only consider portfolios valued at between £500,000 and £10 million and expect rental income to be in the region of 130% of the loan repayments. Because the loan is more akin to a credit facility the interest rate charged is often more competitive than rates on smaller individual mortgages but you are buying flexibility here as well as knowledge that tax relief is available in full.
Use of main residence
Again, the same method of releasing equity could be used to purchase another main residence. The original main residence is rented out becoming part of the ‘portfolio’ and the funds are then used to purchase a replacement main residence. Full tax relief is allowed on interest paid on a mortgage that has effectively been used to purchase at least part of a new main residence or if the credit available over the entire portfolio is high enough then full purchase is possible.
Full tax relief against property income for such a ‘portfolio’ remains but the same restriction as given above applies, namely that the total equity released must be less than the market value of the property when brought into the letting business - in this case the date of renting.
Mortgage Interest and ‘rent-a-room’
Should this method of ‘equity release’ be used to finance the purchase of a main residence which is then subsequently partly rented out on a ‘rent-a-room’ basis then the interest paid on the loan cannot be claimed as a deduction in the rental business. See issue 15 (November 2011) for details of the ‘rent a room’ tax exemption.
The conclusion as per the initial article still applies - the higher mortgage amount will mean higher interest payments leading to a reduction in profit and therefore a smaller tax bill.
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