HMRC appears to have changed its long held views on the availability of tax relief on interest charged on new borrowings by property business owners who remortgage their property to withdraw capital from their business. 

If this is a genuine change it may well impact on thousands of buy-to-let owners.

  • A business owner may claim tax relief on the interest costs of loans made to refinance a business.
  • Refinancing may allow the owner to withdraw capital (see the examples below).
  • HMRC appears to have rewritten its guidance on this subject for property owners and the effect is that there will be no tax relief for extra costs of interest on a remortgaged property.

It is unclear is this is a policy change or an accidental error during the re-write of their Property Income manual (PIM) following the April 2017 Restrictions on Mortgage Interest Relief.

Historically, the rules, and examples, have regarded withdrawal of capital as being for the purposes of the trade since rental income became subject to the same accounting principles as trading businesses (2005/06). This was covered by the trade press in 2005. ICAEW guidance still reflects the position as it was understood prior to HMRC’s changes

HMRC's old PIM guidance

HMRC's previous PIM guidance to landlords who wish to remortgage their letting property was as follows:

HMRC guidance @ 31/12/2016 (it changed in April 2017. according to the ICEAW)

  • You purchased a buy-to-let property for £120,000 with a mortgage of £90,000 and let it to a tenant straight away.
  • Three years later the property is valued at £150,000 and you increase your mortgage on the property to £115,000. All of the interest on the mortgage can still be claimed as a revenue expense as the loan doesn’t exceed the initial £120,000 value of the property when it was introduced to your letting business.
  • If you increased the mortgage to £125,000, the interest payable on the additional £5,000 is not tax deductible and cannot be claimed as a revenue expense.

Using HMRC's old guidance, and assuming that you always withdrew all your rental profits as drawings, the balance sheet would be as follows:

 

3 years ago    

 £

Today     

£

Property original cost 120,000  
Property revalued   150,000
Mortgage (90,000)  
Mortgage   (115,000)
Net assets 30,000 35,000
Represented by:    
Owners' capital account B/f  30,000 30,000
Revaluation reserve   30,000
Less: capital withdrawn   (25,000)
Total 30,000 35,000

 

If you increased the mortgage to £125,000, your balance sheet would be:

 

3 years ago    

 £

Today     

£

Property original cost 120,000  
Property revalued   150,000
Mortgage (90,000)  
Mortgage   (125,000)
Net assets 30,000 25,000
Represented by:    
Owners' capital account b/f  30,000 30,000
Revaluation reserve   30,000
Less: capital withdrawn   (35,000)
Total 30,000 25,000

 

HMRC's New Property Income guidance

HMRC Property income @ ?  2017

If you increase your mortgage loan on your buy-to-let property you may be able to treat interest on the additional loan as a revenue expense, as long as the additional loan is wholly and exclusively for the purposes of the letting business.

Interest on any additional borrowing above the capital value of the property when it was brought into your letting business isn’t tax deductible.

 

If we take the old example and combine it with the new guidance, the additional interest charged on the increased borrowing of £35,000 would only be tax deductible if the funds from the new loan are used wholly and exclusively for the purposes of the letting business. 

When and why?

HMRC appears to have changed its views as part of the re-write of its Property income manuals following the Restriction in Mortgage Interest Relief (subscriber version) rules that apply from 6 April 2017.

The updates section of the Property Income Manual fails to note when the changes were made.

There are no changes to tax relief for companies, loan interest relief for corporates remains is via the Loan Relationship Rules.

Confusingly, HMRC's Business Income Manual (para BIM45700) provides a slightly different version of the rules.

HMRC BIM45700 example 2 (18/10/2017)

A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction. 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.

Example 2

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.

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.

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.

The opening balance sheet of his rental business shows:

Mortgage £80,000 Property at market value £375,000
Capital account £295,000    

 

The balance sheet at the end of Year 1 shows:

Mortgage   £205,000 Property at market value £375,000
      
Capital account B/F £295,000      
  Less Drawings £125,000      
  C/F   £170,000    

 

 

What does the legislation say?

Tax relief for business interest is given by s34 ITTOIA 2005, the rules apply for letting business, however since April 6 2017, there is a restriction in relief for higher earners. 

S34 Expenses not wholly and exclusively for trade and unconnected losses

(1) In calculating the profits of a trade, no deduction is allowed for—

(a) expenses not incurred wholly and exclusively for the purposes of the trade, or

(b) losses not connected with or arising out of the trade.

(2) If an expense is incurred for more than one purpose, this section does not prohibit a deduction for any identifiable part or identifiable proportion of the expense which is incurred wholly and exclusively for the purposes of the trade.

Business income example v old property income example

The BIM example illustrates the withdrawal of capital before the rental business commences.

The old PIM example showed withdrawal of capital whilst the rental business was continuing.