A bigger loan may not mean more tax relief
With the recent increase in property prices, people owning investment properties may be thinking about increasing the borrowings on their investments to release equity and obtain more tax relief on the interest paid. In some cases they might pay more tax than expected…
How the law works

Example 1

In 1996 Mr. Smith bought himself a flat to live in (price £75,000, loan £67,500). In 2004 he decided to buy a new house, but keep the flat (now worth £150,000) as a buy-to-let investment. Under the old rules (see below) he could not have borrowed more than £67,500 against the flat for interest relief purposes. However, now he can extend his mortgage above the original loan before he lets the flat and the interest will all be allowable against rental income.

Example 2

As example 1, except that Mr. Smith increases the mortgage after letting. Remember the letting business has a balance sheet. At the date the letting business started the asset introduced was worth £150,000, hence Mr. Smith has a capital account worth £82,500, as the original loan of £67,500 is a liability. If Mr. Smith subsequently chooses to increase the business loan above £67,500 to withdraw capital he has introduced, then the interest on this will still fully qualify for tax relief.

So, in examples 1 and 2 when the loan was taken out makes no difference in terms of tax relief. The critical aspect is the value of the property when the letting started.

Example 3

In 1996 Messrs. Jones and Brown bought a commercial property for £300,000 and let it to their limited company. By 2004 the property was worth £750,000 and they wished to re-mortgage for substantially more than £300,000 in order to withdraw some equity and pay off personal mortgages on their homes. Here the extra loan is taken above the original price at which the property was introduced to the letting business. The Inland Revenue regard the extra loan above the £300,000 as being a withdrawal of capital greater than the capital originally introduced, and the interest will not be fully allowable.

Example 4

As example 3, but the extra loan above the original purchase price is used to invest in another property for letting or to loan to the business as working capital. Here the increase in the loan above £300,000 is for another qualifying purpose and the interest will be allowable (albeit for a different reason than the letting of the original property). But see right for a possible pitfall.
The historical context
Prior to 6 April 1995 only the interest on a loan taken out to buy a property qualified for tax relief against rentals received. From that date, the relief changed to normal trading principles, where the interest had to be incurred wholly or exclusively for the purpose of the rental business. This seemingly small change has made a big difference.

Barnes Roffe Topical Tips

• When properties used in letting businesses are geared up by a re-mortgage care must be taken to ensure that the loan remains qualifying for tax relief.
• Monies lent to a trading company to provide working capital will get tax relief on the interest paid by the individual. However, if the individual withdraws the money lent to the company over time, but does not use it to pay down the borrowing concerned, then the tax relief on that borrowing will be reduced pro-rata.

Topical Tips is designed to be a simple and useful source of ideas and information for clients and contacts of Barnes Roffe LLP. If you are unsure about the implications of any idea contained therein please contact your Barnes Roffe LLP partner. Barnes Roffe LLP cannot take responsibility if the ideas are implemented without its involvement.