Low Interest Rates? Renovating/Extending Your Property

Lee Sharpe looks at the prospects for property renovations, etc., in the brave new low-interest, post-Brexit world.

Just a few weeks ago, we were warning of serious problems ahead for many highly-geared buy-to-let (BTL) landlords thanks to the new rules that will restrict interest tax relief, from April next year. Worse, we expected interest rates to rise, now that we were clawing our way out of the last global recession, which would have exacerbated those landlords’ problems. A mere hop, skip and a referendum later, and the outlook has markedly changed.

Whatever else may befall us as a result of our divorce with the mainland, it seems that interest rates are set not to rise. In fact bankers, it seems, are already staring into the deep, dark abyss of negative interest rates (be still, my ‘bleeding’ heart!). Based on reported discussions at the Bank of England, it looks very much like interest rates will not rise but will be reduced, as part of their strategy to stabilise the economy.

From a tax perspective, this news could not come at a better time for BTL investors. Those on long-cherished tracker mortgages may not yet quite believe their good fortune. Other landlords may simply be relieved that the impending restriction of tax relief on interest for residential mortgages may not cost quite so much, simply because the interest itself may soon fall. Not so much ‘Apocalypse soon’ as ‘Apocalypse postponed’!

 

Some commentators predict that the reduced rates of interest will usher in a new era of conversions, extensions and renovations. What does the new, ultra-low interest world mean, from a tax perspective?

First off, this is great news for individual BTL investors with mortgages: they will basically get to keep most of the real-terms reduction in interest costs. The benefit is almost always £800 per £1,000 of interest saved – even for higher-rate taxpayers – by 2020/21.

Pippa has a tracker mortgage that currently costs her £3,000 in interest. Her rental profits are currently £4,000 but she is a 40% taxpayer, because of other income. Conveniently, she has no other letting expenses. Let’s compare 2016/17 to 2020/21, where interest has been completely added back, and replaced with a corresponding 20% tax credit against her overall tax liability. 

In 2016/17, her rental profits will cost her tax of (£4,000 @ 40%) = £1,600.

Net of mortgage interest and tax, her rental yield will be £2,400.

In 2020/21, her tax-adjusted rental profits would be £4,000 + (add back interest) £3,000 = £7,000.

Her increased tax bill would be £7,000 @ 40% = £2,800

Less basic rate tax reduction of £3,000 @ 20% = £600

Net tax would be £2,200 – an increase of £600 on 2016/17 

(alternatively, £3,000 interest x (40% marginal rate – 20% reduction in tax liability) = £600)

Pippa’s net income in 2020/21 will therefore be £7,000 - £3,000 interest - £2,200 tax = £1,800.

Let’s assume that interest rates do indeed fall, and Pippa’s interest costs go down to £2,000. 

Pippa’s real profits rise to £5,000, which would in 2016/17 cost her £2,000 in 40% tax.

In 2020/21, her interest adjustment will be just £2,000 – costing her just £400 extra tax: 

£2,000 x (40% marginal rate – 20% reduction in tax liability) 

Pippa’s net income in 2020/21 will therefore be £7,000 - £2,000 interest - £2,400 tax = £2,600.

So, saving £1,000 in interest will mean saving £800, after tax adjustments, come 2020/21.

In fact, this rule applies at almost any tax rate. Perhaps the easiest way to explain the net tax effect is to consider that, in 2020/21, when all interest is added back, the amount of interest is almost irrelevant, because the landlord will be taxed on gross income effectively before interest (ignoring other expenses). 

If his or her interest bill were to increase by £1,000, then his taxable rental profits would be the same in 2020/21 at any amount of interest, once interest has been fully disallowed; the only real change would be that the extra £1,000 interest will save £200 in the 20% tax reduction that compensates for losing interest relief directly. So, he will have spent an extra £1,000 in interest but saved an extra £200 in tax credit – an £800 real-terms cost for each extra £1,000 interest spent.

If some commentators are right, and falling interest costs mean that BTL investors will look to extend or develop new property, are there any other tax implications?

Unless someone fixed the UK’s housing crisis while I was busy watching the EU referendum, the UK still has a serious and chronic shortage of suitable housing stock (that isn’t empty ‘zombie’ property, or simply in the wrong area). You might think that the government would want to avoid anything that got in the way of building new housing stock. You’d be disappointed.

New ITTOIA 2005 s 272B(3) confirms that a property business that borrows money to create or develop a dwelling will still be caught by the new interest regime, and subject to interest restriction from April 2017. Investors who build to let are seriously disadvantaged against traders who build to sell. Strategically, it surely means fewer homes will be built, as some property investors will be dissuaded from borrowing to build. 

Generally, where projects will affect the capital value of a property, then the investor will not get tax relief against their property business for those building costs. Typical projects would be extensions, additional bedrooms, loft conversions and similar. 

Replacing kitchens or bathrooms will normally be revenue expenditure, unless the quality of the replacement kitchen and/or bathroom is better than the original – when it was originally installed. But if the replacement also includes (say) adding extra kitchen units, or a new shower where there wasn’t one beforehand, then that element would comprise capital expenditure and, like almost all capital costs, would be deductible on the sale of the property (assuming the addition is still present).

The construction industry scheme (CIS) makes the property developer liable to account for tax on payments made to those who undertake sub-contracted construction work for him. This would apply where the developer engages plumbers, bricklayers, electricians, etc. Private homeowners are not caught by the CIS regime. 

Trading property developers are, and should be, familiar with the requirement to report monthly to HMRC, to withhold tax from payments in some cases and to pay that money over to HMRC as required. Fortunately, property investors are not normally considered ‘mainstream contractors’ but there is a risk that HMRC will deem property investors who embark on a substantial project as being caught by the regime (see their Construction Industry Scheme manual at CISR12080). I should add that I think HMRC’s guidance on this point is highly questionable. 

I am not sure yet that I share come commentators’ optimism for property investors, but I can see that falling interest rates might be cause for careful celebration by BTL investors with mortgages and perhaps some will see opportunities to enhance their portfolios. So long as they are aware of how their borrowing costs will be artificially affected by tax changes over the next few years, then they should be well placed to estimate if new ventures will prove worth their while.