In his Summer Budget (2015) George Osborne announced that landlords’ ability to deduct finance costs from their income would be ‘limited’ to the basic rate of tax – currently 20 per cent.
This is described in the ‘Red Book’ as:
1.191 - The government will restrict the relief on finance costs that landlords of residential property can get to the basic rate of income tax. The restriction will be phased in over 4 years, starting from April 2017. This will reduce the distorting effect the tax treatment of property has on investment and mean individual landlords are not treated differently based on the rate of income tax that they pay. It will also shift the balance between landlords and homeowners.
And is subsequently being legislated for in the Finance Bill 2015/16, introduced shortly after the Budget. The Bill outlines plans to gradually remove the ability to deduct finance costs between 2017 and 2020, with the new regime taking hold fully from tax year 2020/21.
Rather than allowing deductions, the new system will allow landlords to apply a ‘reduction’ equivalent to 20 per cent of their finance costs to their tax bill. However, crucially this will force landlords to declare a higher pre-tax income (including their finance costs) potentially pushing thousands into a higher Income Tax band.
During the transition period the two systems will run in tandem with the proportion of relief gradually shifting from the old to the new.
HM Revenue and Customs explains this as:
- 2017 to 2018 the deduction from property income (as is currently allowed) will be restricted to 75% of finance costs, with the remaining 25% being available as a basic rate tax reduction
- 2018 to 2019, 50% finance costs deduction and 50% given as a basic rate tax reduction
- 2019 to 2020, 25% finance costs deduction and 75% given as a basic rate tax reduction
- 2020 to 2021 all financing costs incurred by a landlord will be given as a basic rate tax reduction
Individuals will be able to claim a basic rate tax reduction from their Income Tax liability on the portion of finance costs not deducted in calculating the profit. In practice this tax reduction will be calculated as 20% of the lower of the:
- Finance costs not deducted from income in the tax year (25% for 2017 to 2018, 50% for 2018 to 2019, 75% for 2019 to 2020 and 100% thereafter)
- Profits of the property business in the tax year
- Total income (excluding savings income and dividend income) that exceeds the personal allowance and blind person’s allowance in the tax year.
Any excess finance costs may be carried forward to following years if the tax reduction has been limited to 20% of the profits of the property business in the tax year.