My client owns two properties, both bought with a mortgage, but one loan has since been paid off.
The property that is still mortgaged is my client's home; the unencumbered property is let out at a commercial rent to unconnected tenants.
My client owns two properties, both bought with a mortgage, but one loan has since been paid off.
The property that is still mortgaged is my client's home; the unencumbered property is let out at a commercial rent to unconnected tenants.
My client advises that in theory he could have paid off either mortgage, but for administrative reasons he paid off the loan on the rented property. He feels that the loan interest he does pay (i.e. on his home) represents the cost of freeing capital for his rental business, so should he be allowed to claim a deduction for the loan interest paid?
It seems unfair that the allowability of interest should be so dependent on which property's loan is still outstanding when the situation, if viewed as a whole, is much of a muchness.
Even if the distinction is important for tax reasons, can this be overcome by transferring the outstanding loan from one property to another?
Readers' views will be appreciated.
(Query T16,087) - Zain.
A deduction is allowed for interest paid on a loan wholly and exclusively for the purpose of a Schedule A business. The client had a mortgage on his house and a mortgage on the let property. The wording of the query indicates that they are separate loans.
It would have been helpful if 'Zain' could have shed some light on the administrative reasons for the client's decision when the mortgage was redeemed, as it becomes necessary to make some guesses.
A mortgage on a let property is normally treated as a commercial mortgage by the lender and so will be treated differently. For example, the loan to value ratio will usually be restricted to 75 per cent, although this is sometimes relaxed. The interest paid on the loan is usually at the variable rate for the lender. Lenders offer a bewildering array of fixed rates and capped rates for residential mortgages, but they usually incorporate a redemption penalty.
For 'Zain's' client, the rate of interest may have been greater on the commercial mortgage. Redeeming the mortgage on the let property would not give rise to a redemption penalty, but redeeming the residential mortgage might have triggered a penalty. Another pointer in favour of keeping the residential mortgage is that the greater loan to value ratio for that mortgage would give the client greater scope to release equity by securing an additional advance.
However, the client may not have factored in the tax deductibility of the interest on the commercial mortgage. Indeed, if some of my clients are anything to go by, he probably did not realise that there was a problem, and only told 'Zain' after the mortgage had been redeemed.
'Zain' comments that the two loans were a global source of funding for the client's house and the let property. Has this position been reflected in past tax returns? If so, 'Zain' would have taken the interest on both loans and apportioned the total interest between the two mortgages, with the part relating to the commercial mortgage being entered on the land and property schedule. I suspect that this is not the case, and so this argument would be inconsistent with past returns.
The situation cannot be remedied by transferring the loan from one property to another. The purpose of the remaining mortgage will still be to purchase the client's residence; it will simply be secured on a different property. In this respect, I would refer 'Zain' to the guidance in the Inland Revenue's Inspector's Manual at paragraph IM778 on the deductibility of interest paid on loans used for non-business purposes. As the rented property is already owned by the client and is currently unencumbered, how could the interest on a new mortgage on the let property be for the purpose of a Schedule A business, given that it would just replace the mortgage on the client's house? It could not. - Hodgy.
For expenditure to be allowable as a deduction in computing the taxable profits of a Schedule A business, it must be incurred wholly and exclusively for the purpose of the business, i.e. to earn rental income.
The purpose of the loan is a question of fact - the client took out the loan in question to finance the purchase of his main residence. The fact that by paying off the mortgage on the rental property he freed up capital for the rental business does not satisfy the wholly and exclusively rule.
'Zain' also queries whether it would be possible to overcome this problem by transferring the outstanding loan from one property to another. If the client takes out a mortgage on the rental property and applies the funds in paying off the borrowings on the main residence, again the wholly and exclusively test will fail because the purpose of the borrowing is not to enable rental income to be earned. - KL.
Extracts from further replies received:
'Zain' refers to the commercial mortgage being repaid for administrative reasons. Is that a euphemism for the commercial property interest charge being greater than that on the private residence mortgage? The client must live with the transaction that took place. I suppose it might be possible to transfer ownership of the property to, for example, an interest in possession trust but that is almost certain to trigger a liability to stamp duty (we are not told the value of the property) and other administrative costs, which may reduce any additional tax relief. As always, it is the real transaction that determines the tax consequences. In some cases the Revenue gains and in others our clients gain because a transaction has been properly structured. Falling on the wrong side of the line has appropriate consequences; the tax system does not operate like major high street stores and birthday jumpers; you cannot take your loan back until you get one you like. - Flipper.
What 'Zain' needs to do is to consider the problem on the assumption that his client is completely separate from his business. A balance sheet should be drawn up to include all assets and liabilities of the Schedule A business at original cost. From the information given, it is assumed that there will be a balance on the client's capital account (effectively representing net monies introduced into the business) which is greater than the loan amount. Effectively, the client has lent this money to the business interest free, and now the money is to be repaid. The money is to be repaid through obtaining an interest-bearing bank loan. In this case there seems no reason why the interest should not be allowable. The case would seem no different from a company repaying finance through renewed finance or from a partnership repaying a partner's capital account using an overdraft.
If the capital is overdrawn, however, the Inland Revenue would argue that the loan (or part thereof) has been used to fund private expenditure. In this case all, or a proportion, of the interest would be disallowable.
Finally, although inconvenient, the transactions should be physically undertaken, i.e. a new loan should be taken out and banked in the Schedule A bank account, then subsequently withdrawn to repay the mortgage. - TC AT.
Editorial note. It should not be overlooked that section 787, Taxes Act 1988 can be applied to schemes designed to achieve tax relief for interest payable.
