Instead, taxable profits will be calculated ignoring finance costs, and income tax charged accordingly. A basic rate tax reduction can then be claimed against the finance costs.
The changes will be phased in gradually from 6th April 2017, taking full affect from 6th April 2020. HMRC have recently issued guidance and case studies to help in understanding how the new rules will work.
The changes will apply to all UK resident landlords regardless of whether the property is in the UK or overseas. They will also affect trustees or beneficiaries taxable on trust income, but they won’t affect commercial properties, companies letting out residential property or furnished holiday lets.
Perhaps an unintended consequence, or perhaps not, is the potential effect in areas such as Child Benefit entitlement, Personal Allowance entitlement, Capital Gains Tax and the Pensions Annual Allowance.
Currently a person with rental income, after allowable expenses, of £20,000 and finance costs of £10,000, would, for the purpose of calculating entitlements and tax rates, have an income of £10,000. This income would be taxed accordingly based on their own rates and allowances.
Once the new rules take full effect, the same person will have an income of £20,000. This will be taxed accordingly based on their own rates and allowances, with a tax reducer applicable to give basic rate relief on the finance cost.
Importantly, if this increase in income takes the individuals earnings over the basic rate band, Capital Gains Tax may be payable at a higher rate, over £60,000, Child Benefit is lost, over £100,000 the Personal Allowance starts to be lost and over £110,000 the Pensions Annual Allowance may be affected.
The Pensions Annual Allowance is the maximum amount which can be paid into a pension each year, tax efficiently. The allowance currently stands at £40,000 per year, but new rules which took effect this April, mean that those with ‘adjusted income’ over £150,000 will be subject to a tapering of their allowance. ‘Adjusted income’ is broadly, taxable income (salary, bonus, benefits in kind, self-employment income, pension income, savings income, dividends, chargeable events etc.) plus pension contributions (except those which are deducted from net income).
Tapering means that for every £2 of income that exceeds £150,000, £1 of the annual allowance will be lost. The maximum taper is £30,000 to give a minimum annual allowance of £10,000 (which is reached at an income level of £210,000 plus).
Further rules apply to ensure new salary sacrifice arrangements cannot be used to reduce ‘adjusted income’ and also to ensure that one off spikes in pension contributions do not create a tapering which would not otherwise apply. Carry forward rules also remain in place.
The example below demonstrates how the change in treatment of buy to let income could affect the annual allowance.
Peter has a salary of £120,000. He makes personal pension contributions which are deducted from his net pay and his employer contributes £20,000 a year to his pension. Peter also has a buy to let property, from which he receives £20,000 of income each year. The mortgage on this property costs £10,000 a year.
Under the current rules, Peter’s ‘adjusted income’ would be £150,000, made up of his salary, his employer pension contribution and his net rental profit.
Once the new rules take full effect, his ‘adjusted income’ will be £160,000, made up of his salary, his employer pension contributions and his rental income of £20,000.
As his income is over £150,000, by £10,000, Peter’s annual allowance will be tapered by £1 of every £2 of income, resulting in an annual allowance of £35,000.
With ever increasing complexity the tax system, and ever changing pension rules, it is vital clients who could be affected seek advice. If you would like more information, or a review of your own position, please contact your normal adviser, or Jo Penly at Skerritts on 01273 204999 or email@example.com
Please note that these are our opinions and for information only. The information contained within this document is for guidance only and is not a recommendation of any investment or a financial promotion. Skerritts are not a tax specialist and individual advice should be sought before you proceed. Skerritts are also not responsible for the accuracy of any information contained within HMRCs website. Tax advice is not regulated by the Financial Conduct Authority.