Remortgaging property for letting - unexpected tax relief on additional interest


04-10-2004

A change to the Inland Revenue's treatment of business income (Business Income Manual paragraph 45700) challenges the assumption that if you let your property and increase the mortgage on it, you cannot get tax relief on the additional interest.

Mark Baines, tax partner at Deloitte, comments: 'People who let their properties may not realise that if they increase their mortgage they might get tax relief on the extra interest. This could come as a surprise to many, as conventional wisdom has it that the relief is only available on borrowings for the purchase or improvement of the property. The following examples make this clear:



1. Some years back, Alan bought a property for letting. He borrowed 75% of the cost and provided the remaining 25% out of his own funds. The property has now doubled in value. If he also doubles his mortgage, thereby releasing money to help him buy a second home in the country, would the interest be deductible for tax purposes against the rents?



2. Priscilla trades up to a better home. Instead of selling her old one she lets it. Because its value has gone up since she bought it, her mortgage is comparatively low. If she ups the mortgage, will the additional interest be deductible against her rents?



'In neither case is the borrowing for the purchase or improvement of the let property. Indeed, if the money has actually been used in the purchase of a new home, it doesn't seem to have anything to do with the letting.



'Before seeing see why each gets a good tax deal we need to be aware of a recent entry in a Revenue Manual which makes two things clear:



* As a landlord, one can choose how much of the initial capital invested in the property should come from one's own resources and how much to borrow, and one can switch between the two; and

* Where one first lets one's previous home, the initial capital is not its original cost but its current market value.





'It follows that Alan can borrow the remaining 25% of the original cost to release the money he originally funded and invest it in his second home. He would then get relief for the whole of his interest against his rents. What he can't do, though, is take his borrowings to more than what the property originally cost him, as that represents his initial capital.



'Priscilla can do even better: she can borrow up to (say) 75% of the value of her former home and get relief for the interest. The reason is that she is regarded as bringing it into her letting business at its current value, and that is what represents her initial capital in the business.'







  • It's commonly stated that tax relief on interest is only allowed against rents if the funds have been used to purchase or improve the property. This used to be the case under 'old' Schedule A, and it would normally prevent interest relief being obtained on money borrowed after the purchase and not used for improvements. Under 'new' Schedule A, however, applying from 1995, the test has been whether, like any other letting expense, the interest has been incurred wholly and exclusively for the letting business.



    This appeared to give wider scope for relief where a refinancing allowed money to be released for personal use. It was not clear that the Revenue consistently believed it did, and even today commentators continue to say the extra borrowing must be for the purchase or improvement of the property.



    We now have paragraph 45700 of the Revenue's Business Income Manual which confirms the two principles set out above. For Priscilla, their example 2 lays the position out clearly.



    It reads:

    'Mr A owns a flat in central London, which he bought ten years ago for 125,000. He has a mortgage of 80,000 on the property. He has been offered a job in Holland and is moving there to live and work. He intends to come back to the UK at some time. He decides to keep his flat and rent it out while he is away. His London flat now has a market value of 375,000.



    The opening balance sheet of his rental business shows

    Mortgage 80,000

    Property at MV 375,000

    Capital account 295,000



    He renegotiates his mortgage on the flat to convert it to a buy to let mortgage and borrows a further 125,000. He withdraws the 125,000 which he then uses to buy a flat in Rotterdam.



    The balance sheet at the end of Year 1 shows

    Mortgage 205,000

    Property at MV 375,000

    Capital account B/F 295,000

    Less Drawings 125,000

    C/F 170,000



    Although he has withdrawn capital from the business the interest on the mortgage loan is allowable in full because it is funding the transfer of the property to the business at its open market value at the time the business started. The capital account is not overdrawn.'



    For Alan, a statement in their example 1 gives the answer. Although it apparently relates to a trade rather than a letting business, the principles are the same. It reads:



    'Proprietors of businesses are entitled to withdraw their capital from the business, even though substitute funding then has to be provided by interest bearing loans. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business. There will though be an interest restriction if the proprietor's capital account becomes overdrawn.'



    The 'wholly and exclusively' rule, as interpreted by the Revenue, therefore offers considerably more scope for interest relief than the 'purchase or improvement' rule.





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