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Replies to Queries - 3 - Allowable proportion

13 November 2002
Issue: 3883 / Categories:

In 2000, a property was purchased as a 'buy to let' investment for £200,000. This was funded by cash and a repayment mortgage of £60,000. The interest on this repayment mortgage was deductible against rental income.

In 2000, a property was purchased as a 'buy to let' investment for £200,000. This was funded by cash and a repayment mortgage of £60,000. The interest on this repayment mortgage was deductible against rental income.

In 2002, a remortgage was required to extract a large portion of the equity for other purposes (unrelated to the Schedule A business). As a result of the housing boom, the property was now worth £240,000 and a new mortgage of £192,000 was taken out to repay the balance on the existing mortgage and release funds. This new mortgage is interest only for a few years before becoming repayment.

With little legislation and guidance from the Inland Revenue, the reader finds himself pondering how much of the interest on the new loan is actually deductible.

(Query T16,110) - Interested.

 

From the information given, the answer to 'Interested's' query is quite straightforward. We are told that the original loan to purchase the property was for £60,000 and that quite correctly the interest on it was deducted from rental income.

This mortgage was then replaced by a new loan for £192,000 of which a part was to repay the original mortgage and a part was for personal use. Interest on the personal element will not be deductible. Interest on the element that just replaced the original loan will qualify, as before, as a deduction. As the original mortgage was a repayment mortgage, the proportion of deductible interest will be calculated as the outstanding balance on the old mortgage (not £60,000) divided by £192,000. This proportion will continue to apply in future years as the mortgage is repaid, and also in the event that there is a further remortgage.

Had a part of the new mortgage been used to pay for improvements to the property, an increased proportion of the interest would have qualified for relief.

Where a rental property is to be used as security for personal borrowings, it may be better to take two loans. First, the remortgage is completed, but on interest only terms. Secondly, the personal element is dealt with by a repayment mortgage with a term that is shorter than would have been the case for the originally proposed single loan for the total amount. In this way, it should be possible to ensure that the loan is repaid on the same time scale, but with significantly enhanced deductible interest. In effect, the business element of the loan represents an increasing proportion of the total borrowings. Ultimately of course the point will be reached where the interest only loan also needs to be repaid.

For further information on this, 'Interested' could refer to Inland Revenue booklet IR150. The reply to query T16,087 in Taxation, 1 October 2002, may also useful. - Wentworth.

 

I think the easiest way of looking at this situation is to appreciate that there need not be a link between any particular borrowing or the security (if any) for that borrowing. That is, it is the purpose to which those borrowings are put that is important, not what security is offered.

Accordingly, 'Interested' has in effect answered his own query. It appears that the original £60,000 was all in connection with the property which is now let and thus the interest on that loan was all deductible in the Schedule A business computation.

The remortgage entailed that £60,000 loan being repaid and replaced by a new £192,000 loan. Accordingly, it follows that interest on £60,000 worth of the new loan continues to be deductible in the Schedule A business computation, but interest on the other £132,000 part of that loan is not. It is not deductible because, as 'Interested' says, it was incurred for 'other purposes (unrelated to the Schedule A business)'. The ability to split the loan into the two elements is confirmed in the Inland Revenue's Inspector's Manual at paragraph IM776, given that the profits of a Schedule A business are computed in the same way as for a 'real' business. - JRL.

Extract from reply by 'Bear':

The useful inference to be drawn is that the cash advance at the time of purchase in 2000 represented a temporary expedient for 'Interested', pending the completion of the intended financing, of which £60,000 was a provisional step. Time constraints might have emerged on the occasion of a purchase at auction, while the search for a long-term mortgage on favourable terms could be a lengthy process, even if surveyor's and credit status reports were not a significant obstacle.

It is understood that the Revenue's Relief Manual recognises interest relief on loans drawn down up to six months after the expenditure is incurred. However, in a business context no artificial time limits should be allowed to restrict reasonable matching of purchase money and related finance.

Issue: 3883 / Categories:
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