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Low Interest Rates – A Problem for Some

Low Interest Rates – A Problem for Some
Wednesday 8th October 2008 will go down in history as the day the Bank of England finally acknowledged the extent of the credit crunch triggering a series of panic interest rate cuts down to a low of 0.5%.


This was good news for the bankrupt banks, enabling them to rebuild their balance sheets by not passing the full extent of the cuts onto loan customers, whilst at the same time reducing savings rates down to a level where it is no longer worth putting money aside for a rainy day.


Predictions that there will be four more years of rock-bottom interest rates is bad news for savers, but will leave millions of people with base rate tracker main residence mortgages happy. Landlords may view the situation differently as the reduction in interest rates means an increased tax bill for many. Is there anything that can be done to reduce the bill?


Capital Repayment Mortgage


The traditional type of mortgage is where the property will automatically be the borrowers at the end of the mortgage term. The monthly amount paid is part capital repayment (i.e. repayment of the money borrowed) and part interest payment.


In the early years of the loan the mortgage payments comprise more interest than capital repayments, however, nearer the end of the term the outstanding capital amount will have been reduced such that the payments will be more capital than interest. Only the interest part of the monthly payment is allowed as deduction from rental income for tax purposes; capital repayments cannot be offset.


 Interest-Only Mortgages


The monthly payments cover just the interest element of the loan. No payments are made to reduce the capital therefore at the end of the mortgage term the debt must be repaid in full or the lender is allowed to repossess the property. More interest is paid on this type of loan as the whole capital sum is borrowed for the entire term, rather than gradually reducing over the term. The full amount of payment is deducted from the rental income for tax purposes

 

Offset Mortgages


These mortgages are a type of interest - only mortgage and are a relatively new concept in the UK where savings are set against the mortgage debt. By giving up earning interest on savings, reduced interest is paid on the mortgage. At the end of the term the mortgage must be repaid in full from either the savings held or from other sources of finance.

 

Rules for obtaining tax relief on mortgage interest payments:-


• HM Revenue and Customs (HMRC) deem the renting of a property to be a business (see http://www.hmrc.gov.uk/manuals/pimmanual/PIM1020.htm)  and the interest payable on loans used to purchase that property (or to fund repairs, improvements or other alterations) is fully deductible for tax purposes as an expense in computing the profit or loss of that rental business.


• The amount of relief is restricted to the property’s value at the time that it first became a rental property. If the property had originally been purchased purely for the intention of letting, this amount would be the purchase cost; if originally the main residence subsequently let the value is as at the date the first amount of rental income is received.


• The property must be let at a commercial rent and a written or verbal tenancy agreement be in place.

 

The Problem:


Authorities confirm that the number of properties available for rent is reducing as renters elect to stay put rather than move as jobs get scarcer.

 Banks are rationing mortgages (mortgage approvals fell to a four-month low in June) therefore people who would usually buy are renting instead waiting for the situation to improve.


As such rental payments are increasing whilst interest rates remain at an all-time low. The profit on renting is therefore increasing, resulting in an increased tax bill.


What Can Be Done to Reduce the Tax Bill?


Idea 1: Ensure that all allowable expenses are claimed.  A list can be viewed at: http://www.direct.gov.uk/en/MoneyTaxAndBenefits/Taxes/TaxOnPropertyAndRentalIncome/DG_10014027


Idea 2: Use the increased rental income received to improve the property; this will not reduce the current tax bill but will retain and enhance the property such that the cost can be added to the purchase price resulting in a reduced capital gains tax bill on sale.


Idea 3: Remortgage to release equity/value in the property. The additional amount raised can either be used to purchase another property whilst prices are relatively low or be used to reduce the mortgage on the main residence. HMRC specifically allow landlords this method of tax planning regardless of the purpose of the equity release – see www.hmrc.gov.uk/manuals/bimmanual/BIM45700.htm


The only restriction is that the total equity released must be less than the market value of the property when brought into the letting business.


The higher mortgage amount will mean higher interest payments, a reduction in profit and therefore a smaller tax bill.


Normally interest relief on a main residence cannot be claimed as the property does not form part of the property business, only mortgage interest on a letting property being allowed but this is a way that not only reduces the tax bill but effectively allows tax relief on interest paid to purchase a main residence.


Example


Five years ago Jane purchased a rental property for £250,000 using a mortgage of £200,000 and £50,000 deposit from personal funds. The property has now increased in value to £300,000. She remortgages the property taking out a loan of £250,000 and is thus able to release £50,000 equity from the property.


These funds are used to reduce the mortgage on her main residence; tax relief for the full mortgage amount of £50,000 can be deducted from the rental income. 


As the amount of equity released has not taken the borrowing over the original purchase price of £250,000 the full amount of interest charged is allowed resulting in a reduction of rental profit and tax paid whilst also reducing the amount of loan and interest paid on any remaining loan charged on the main residence.


The same method of releasing equity could be used to purchase another main residence. The original main residence is mortgaged and the funds used to purchase a replacement main residence. The original main residence is then rented out and full tax relief is allowed on interest paid on a loan that has effectively been used to purchase a new main residence.


Idea 4: Use the increased rental income to make overpayments on the capital element of the mortgage. You need to check that the mortgage provider allows overpayments.


If allowed, this will reduce the outstanding balance, producing lower interest payments, resulting in a smaller deduction against the rental income but a higher tax bill. However, this might not be as drastic as it sounds as a basic rate taxpayer will pay an additional 20 pence tax for every £1 in interest saved. Therefore, although more tax will be paid a greater amount can be saved in interest.

 

Practical Tip


To reduce the tax bill make sure that all allowable expenses are claimed; this might mean remortgaging to increase the amount of interest allowed against rental profit.


It is of personal choice but also a cashflow issue whether payments are made to pay off any mortgage quicker than the term set.