Hidden rule uncovers funding By Isabel Berwick
Financial Times Published: March 4 2005 16:36
Thousands of buy-to-let property investors are missing out on a little-known Inland Revenue rule that could cut the tax bill they pay on rental income.
Under widely-recognised Revenue rules, mortgage interest payments on buy-to-let properties can be offset against rental income from tenants. But many buy-to-let investors are failing to take advantage of much overlooked rules that could allow them to increase the mortgage on their rental properties, release some cash and, in the process, cut their tax bill on rental payments. Any cash lump sum extracted from their buy-to-let property could then be used towards a new family home, or to pay off chunks of the mortgage on a main residence which doesn¹t normally attract any tax relief.
Accepted tax wisdom is that increasing the mortgage on a rental property in order to release cash can only attract tax relief when the money is used for buying or improving the property. Many investors therefore have been advised to set up complex property transactions between spouses in a bid to overcome this rule.
But close reading of the Revenue's guidance and a written note from tax inspectors has convinced many leading accountants that it is possible to borrow more on the rental home, free the cash for any use, and get interest relief against the rental income. on the buy-to-let property.
Mike Warburton, tax partner at Grant Thornton, has been studying the rules closely and says the new guidance has been in place for ten years with very few people noticing: "In the old days, until the 1995 Finance Act, the rule for investment properties was that you could claim a deduction for interest paid on a loan applied in purchasing, or improving, land or property. In other words, it was the purpose to which the money was put, not the property on which the loan was secured."
In 1995, the rules changed to allow property investments to be taxed in the same way as any other trade. The Revenue has confirmed to Grant Thornton that tax relief will be provided as long as a loan "is a business loan and the taxpayer's capital account is not overdrawn".
This is an important point. The valuation of the buy-to-let property, used used to calculate how much cash can be extracted, is the property's cost when it was bought by the investor in a business capacity. Taking account of any increase or rise in house price rises since that time is not allowable as this higher property price would be deemed a "notional" value. It could mean that you have borrowed more than the original capital you put into the property and this and this is against the rules.
There is a useful exception to this rule. Homeowners who move out of their main residence to a new home but keep the first house it as a buy-to-let investment can claim the full value of the original home house as a business asset from they date they start treating it as a buy-to-let property. This means homeowners may have more scope to raise cash to fund a new home and keep the original property as an investment.
Warburton suggests investors who plan to make the most of these tax breaks need to be very organised, and keep all buy-to-let business records separate from their main personal bank accounts. "They must be able to demonstrate that the funds borrowed have been used wholly and exclusively for the purposes of the business, and to my mind that means taking out the borrowing through a property investment business bank account and mortgages. I do not, for example, think the Inland Revenue would accept a claim for tax relief if someone simply borrowed money on an offset mortgage secured on their own private residence, using the proceeds to buy a holiday home, or a new car."
Some accountants are cautioning against buy-to-let investors rushing to release cash in this way.
Anita Monteith, head of the tax faculty at the Institute of Chartered Accountants, (ICAEW), says: "Quite a lot of accountants are now using this for clients but I am very nervous. I am sure they will change the rules, if not in this Budget then next time."
Monteith also warns that, in the current difficult buy-to-let market, property owners who may already have heavy borrowings must be careful not to land themselves with mortgage deals that have penalty clauses. If the tax rules did change and they are forced to cancel the mortgage, they could be landed with a hefty redemption penalty.
And see: "Letting your home":