Residential landlords have had a rough time of it over the last few years and their ability to claim mortgage interest relief will end in April.

Before April 2017, borrowing money through a buy-to-let mortgage was a tax-efficient method for residential landlords.

Higher or additional-rate (latterly top-rate) taxpayers were even able to get all the tax back on mortgage financing costs.

Since April 2017, the way landlords have to declare their rental income started to change with significantly higher tax bills as a result.

From April 2020, what was once a tax advantage will be a thing of the past when a tax credit based on 20% of mortgage interest payments comes in.

Most of those affected will face higher bills again, although careful personal tax planning before April can mitigate that.

Mortgage interest relief timeline

2016/17: Buy-to-let landlords were able to deduct their entire mortgage expenses from rental income to reduce their tax bill.

2017/18: Tax changes implemented in April meant that 75% of a buy-to-let landlord’s mortgage expenses could be deducted from rental income. The remaining 25% of mortgage interest qualified for the 20% tax credit.

2018/19: It was possible to deduct half of mortgage expenses from rental income, while the other half received the 20% tax credit.

2019/20: Only a quarter of mortgage expenses can be deducted from rental income and 75% of mortgage interest payments receive the tax credit.

2020/21: It goes into full swing and the entire mortgage interest only receives the 20% tax credit.

Mortgage interest relief restriction example

Fergus earns £60,000 a year in self-employed income. He also rents out two one-bedroom flats in Hillhead, bringing in annual rental income of £28,000.

His mortgage interest on the two properties is £12,000 a year, and he has other allowable property expenses of £3,000 a year.

Before mortgage interest relief began to be phased out in April 2017, he could deduct £15,000 from his rental income.

That resulted in Fergus paying income tax at 40% on total income of £13,000 – £5,200.

Assuming the 2020/21 income tax rates remain unchanged, Fergus remains a higher-rate taxpayer and stands to pay income tax at 41%.

No mortgage interest can be deducted from his rental income, therefore income tax will be due at 41% on £25,000 of his rental profits – £10,250.

He will, however, receive a 20% mortgage interest tax credit equating to £2,400. This means net income tax on rental income of £7,850 in 2020/21 compared with £5,200 in 2016/17.

What’s bad about the tax credit?

The tax credit is based on 20% of your mortgage interest payments, which is particularly bad for higher or top-rate landlords.

If that applies to you, this means you can no longer reclaim tax on your mortgage repayments at your marginal rate (often 41% or 46%).

That results in a 21% tax hike for higher-rate landlords and a 25% increase for those paying the top-rate.

With the need to declare on tax returns any income used to pay the mortgage comes the risk of being pushed into a higher tax band.

That largely depends, however, on any income you have from other sources, such as wages, pensions, dividends or investments.

Tax planning steps to take

The tax changes involving mortgage interest relief only apply to residential landlords who are operating as sole traders or partnerships.

Landlords who operate as limited companies are spared from the 20% credit being phased in since April 2017.

Evidence suggests an increasing amount of buy-to-let landlords are incorporating their businesses as a result.

The buy-to-let market is evolving and this reason alone partially explains why limited company buy-to-let is dominating the purchase market. However, this structure may not be appropriate in all circumstances.

At Thomas Barrie, we provide expert support when buying properties as a limited company and offer specialist advice on incorporating a business.

Considerably costs are involved with incorporating a business and this approach does not suit everyone.

Get in touch by emailing or calling 0141 221 2257.