Whether you are an existing landlord or considering becoming one, funding and mortgages will likely be on your mind. Many of you may have already begun your journey as landlords by re-mortgaging a property you owned. It seems straightforward, if you have equity in a property, why not re-mortgage to release some funds? However, it’s important to be cautious of potential pitfalls associated with re-mortgaging. Be aware of the re-mortgaging trap.
While lenders may be willing to provide funds based on your equity, it’s essential to consider the implications regarding tax relief. When assessing how much of the interest and other finance costs can be deducted from the profits of a property business, several factors must be considered. There are restrictions on the deduction of interest and finance costs related to loans or mortgages.
What is the issue?
Historically, many buy-to-let property owners have taken advantage of re-mortgaging to withdraw capital and benefit from rising house prices. For many, it made sense to make their money work harder. This strategy can be effective, but there are some important caveats.
It is crucial to understand that if the mortgage exceeds the original property value including Stamp Duty Land Tax, associated costs like conveyancing fees, and renovation expenses, the relief for mortgage interest will be significantly restricted.
As a side note the capital cost of renovations is not the same as repairs or maintenance. It is normally structural costs that adds value to the property. You can find what is capital renovations and what is repairs here.
If you’re thinking about re-mortgaging to release funds, you need to be mindful of the re-mortgaging trap. It important that you understand the subtle difference to avoid any future surprises. It’s a great idea to speak to an accountant before you purchase the property ensuring all your ducks are lined up.
But on the plus side you may be able to release some funds from your property business and use it for other purposes. You just need to be mindful that the mortgage does not exceed the original capital value when you started the rental business.
Basically speaking, interest relief on the remortgaged loan is restricted to the cost of the original property. The profit or any uplift in market value due to time passing is ignored. We will look at some examples below to clarify as it can be quite confusing.
The ‘wholly and exclusively’ principle
This restriction arises from the ‘wholly and exclusively’ principle, which states that only expenditure incurred ‘wholly and exclusively’ for the purpose of the business can be deducted from its profits.
For example, if a self-employed plumber takes out a loan ostensibly for his trade but then uses that loan to pay for a safari holiday, the interest on the loan is not deductible, as it is not wholly and exclusively for business purposes.
The same principle applies when a property is re-mortgaged: any portion of the new mortgage that exceeds the capital value of the property when it was first brought into the letting business is for non-business purposes. Therefore, the interest on that portion is not tax-deductible. This is the re-mortgage trap.
However, on the flip side so long as your borrowings are less than the capital value, you will be able to “draw” out the funds for any purpose.
Lets look at some examples
Mr. A owns a flat that he purchased many years ago for £225,000, and he currently has no mortgage on the property. He had let out the flat almost immediately as he went to work abroad.
He has now returned to the country and wants to buy a home but keep his rental flat. Mr A’s flat now has a market value of £375,000. He borrows £250,000 against his rental property. He uses the funds to buy a house.
Although he has withdrawn capital from the business, the interest on the mortgage loan is not fully allowable. The loan of £250,000 exceeds the original cost of £225,000 so mortgage interest will be restricted to 90% (225/250) of the loan.
Second similar example
Mrs B purchased a flat for £300,000 in 2020 which she lets out immediately. The property was funded with savings of £80,000 and a mortgage of £220,000. The is now worth £500,000. She wishes to take advantage of the increase in value to release equity of £50,000 to buy a new car.
As the total borrowings of £270,000 are less than the value of the flat when first let (£300,000), interest relief is available in full. It does not matter that she uses the equity released by remortgaging for non-business purposes.
And final example where interest relief is available without a loan
Miss C has a mortgage of £400,000 secured on her main residence. She purchases an investment property for £150,000 and lets the property immediately.
Although she did not take out the loan to buy the property, she invests capital to the tune of £150,000 in its purchase. She can claim tax relief on borrowings to cover this. Consequently, she can claim tax relief for 37.5% of the loan interest paid on the mortgage of £400,000 (150/400 x 100%).
What’s next?
At first glance, managing your own tax affairs may seem simple. After all, it largely involves taking your rental income and deducting a few expenses. However, as with many rules, there can be exceptions when it comes to taxes.
What you may know may only be part of the picture, which is why it’s beneficial to consult with experts who are familiar with all the regulations and any changes that may occur.
Here’s how we work with landlords.
Get in touch via the landlord page of our website if you want more help and for us to look after your affairs.