LOANS - 03.10.2012

Extra tax relief on loans

Tax status of rental income

Until around 15 years ago the Taxman considered that rents received from buy-to-lets and other properties were investment income. There were special rules for calculating profit and while some of these still exist, rental businesses are now largely treated in the same way as others. This alignment has brought some tax advantages.

Tax relief on borrowing

The old rules allowed you to claim a tax deduction from the rent you received for loan interest but only where the borrowing was used to buy or improve the rental property. But now you are entitled to claim the interest on loans used to release equity in the property.

Example. John bought a property for £90,000 in 1995 which he immediately rented to his company. He borrowed £50,000 to help buy this and it’s now worth £180,000. John now wants to help his daughter buy a flat, but needs to borrow to do this. If he simply takes out a loan for this he won’t receive tax relief on the interest. But by borrowing against his rental property the interest he pays qualifies for a tax deduction (see The next step). This is good news for John, but there’s a drawback.

Limited to original value

The rules limit the interest on which John can claim a tax deduction to the difference between the value of a property when it was first rented out and any existing borrowing on it. For example, because John has paid off all but £10,000 of the loan on his rented property and it cost £90,000, he can get a tax deduction for the interest paid on up to £80,000 of his new loan. The trouble is John wants to borrow £120,000 and this means interest on £40,000 won’t qualify for a deduction. But because John is married there’s some neat tax planning he can undertake.

Property shifting

If John gave his wife a share of the property, say 50%, she will be entitled to an equal share of the rent. She can now borrow against the property up to its value at the time she started to receive income from it, i.e. £90,000. John’s qualifying borrowing limit is reduced because he’s given away half the property, but between him and his wife they actually boosted the allowable loan to £130,000 (£90,000 John’s wife + 50% of £80,000 John).

Tip. This tax planning idea would work just as well if John and his wife had originally owned the rented property jointly. John could have transferred his share to his wife and the value of the gifted share against which she could borrow and receive tax relief on the interest would be uplifted in the same way as described above.

No CGT or SDLT

Giving away assets, such as property, can trigger a Capital Gains Tax bill, but a special rule means this doesn’t apply for gifts between spouses. Gifts of property are also exempt from Stamp Duty Land Tax. So there’s no nasty side effects for John or his wife to worry about.

For more information on borrowing against rental property, visit http://tax.indicator.co.uk (TX 13.01.03).