10 Nov Residential rental business interest restrictions – further guidance
In the 2015 Summer Budget, restrictions to tax relief on interest in residential rental businesses were announced, to be introduced from April 2017 as outlined in an earlier article.
The legislation introduced a “just and reasonable” apportionment on finance costs where a property business includes both residential and commercial lettings, as is often the case for farm and rural businesses. HMRC have now provided guidance on how they expect the “just and reasonable” apportionment to be calculated, with some useful examples. Please note that the term “finance costs” is used since as well as loan interest payable on an ongoing basis, there may also be arrangement fees and professional costs associated with obtaining or maintaining the loan which will also be subject to the restriction of relief from April 2017.
Where a new loan is taken out for the improvement or refurbishment of specific residential or commercial property, then Income Tax relief on the finance costs for residential property will be restricted and unrestricted for commercial property. Where the loan is used for a mix of costs relating to residential and commercial property, then the costs should be apportioned on the basis of the total costs for each type of property.
For example, Jane inherits two let cottages and some let barns from her father. She decides to refurbish them spending £30,000 on updating the electrical and heating systems in the two cottages and £20,000 recladding the barns, which she part finances with a £40,000 loan on which she pays annual loan interest of £2,000. To apportion the loan interest and the restriction applying to the residential rental business, Jane multiplies the interest cost of £2,000 by 0.60 (being the amount spent on the cottages as a proportion of the total expenditure). This gives interest of £1,200 to which the finance cost restrictions apply. For a higher rate taxpayer, this will reduce the Income Tax relief on the loan interest by £240 per annum from April 2020 when the new rules come into full effect.
From this approach to apportioning the interest costs, it can be seen that in future it will be beneficial to finance residential property improvements from retained profits (or capital introduced) and commercial property improvements with loans, as necessary. It would be advisable to keep clear records of the application of funds, perhaps by using a drawdown facility on the loan so that it can be clearly seen that it has been applied on the commercial property improvements.
Alternative methods of apportioning loan interest might be appropriate if, for example, an old barn is converted into mixed residential and commercial units, perhaps offices with a flat. In such a case HMRC have indicated that they would accept that comparing the floor areas of the commercial and residential parts of the building would produce a just and reasonable apportionment of the finance costs.
For a larger property business, where there are a number of let cottages and commercial buildings, then as well as having loans which have been taken out for identifiable purposes, there may be a general overdraft facility. HMRC have indicated it would be acceptable to apportion the overdraft interest on the basis of the residential rental income as a proportion of total rental income. This is likely to be the simplest method to adopt, but may not necessarily reflect the use of the overdraft.
HMRC accept that other approaches to apportioning the finance costs may be acceptable if they give a just and reasonable result, such as by apportionment based on the amount of staff time devoted to each element of the business. This approach might be better suited to a mixed residential and commercial development where the overdraft facility is used to finance regular repairs and labour/contractor costs, as well as receipt of the rental income. The costs may in part relate to specific properties, but may also relate to maintenance of the development or estate as a whole, including work on general areas and facilities.
With whatever method is adopted, HMRC expect that the business would be able to justify that method by reference to its records, and would apply the method consistently unless there was good reason to change. An apportionment based on the amount of staff time may be more difficult to evidence unless the staff produce regular time sheets detailing the work done, especially if part of their time relates to maintenance of the development as a whole.
HMRC do not provide guidance as to how the finance costs relating to historic borrowings should be apportioned, but HMRC should accept an apportionment of costs based upon the above approaches. For earlier years it may be possible to show that a loan was used to finance work on residential and/or commercial properties, perhaps by reference to work done in the tax year as a whole.
Property owners should retain documentary evidence to demonstrate to HMRC how borrowings are applied in mixed residential and commercial property businesses, both for borrowings in existence at April 2017 when the restriction on tax relief on finance costs are phased in and also for new projects going forward.
Consideration should also be given in future as to how best residential and commercial property improvements should be financed. If possible, it would be beneficial to take out loans for trading purposes or commercial property developments, so that residential property work can be financed with retained profits.
If you have any queries, please contact your usual consultant or Carlton Collister on 01993 886418 or firstname.lastname@example.org