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TAX Advice, Buy-to-Let Properties : Deductible interest

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Hi Guys, after reading through some of the comments on here i thought i would drop a bit of my knowledge into this.

There has been a flurry of press and internet articles recently suggesting that the Inland Revenue has changed its policy on giving interest relief when a let property is remortgaged and the money used for a non-qualifying purpose.

Under current legislation, interest is allowed as a deduction against rental income where that interest is incurred "wholly and exclusively" for the purposes of earning rents. Many advisers have long considered that remortgaging a property in order to buy, say, a holiday home abroad is not a qualifying purpose and that interest relief would not be available. Most tax inspectors would be happy not to disagree.

It appears that relief may be more widely available than was thought, as borne out by the Inland Revenue Manuals

There is an argument that a rental property business has to be financed either by capital or borrowings and there is nothing in the legislation to prevent alternating finance between these two sources while still meeting the "wholly and exclusively" test. This viewpoint appears to be supported by details given in the Inland Revenue Manuals, in particular paragraph 45700 of the Inland Revenue Business Income Manual. This paragraph states:

"Proprietors of businesses are entitled to withdraw their capital from the business, even through substitute funding then has to be provided by interest bearing loans. This is on the basis that the purposes of the additional borrowing is to provide working capital for the business. There will though be an interest restriction if the proprietor's capital account becomes overdrawn."

Example 2 in BIM45700 supports this argument. An individual moves abroad and lets out his UK flat; the UK flat has increased in value between the original date of acquisition and the date he first rents the property out; so the individual increases his mortgage on the UK flat to release funds to acquire a property abroad. The manual says: "Although he has withdrawn capital from the business the interest on the mortgage loan is allowable in full because it is funding the transfer of the property to the business at its open market value at the time the business started. The capital account is not withdrawn."

Example 3 in BIM45700 suggests that there is no restriction on the timing of any such re-financing. The proprietor of a small business raises funds secured on the factory, 20 years after it was brought into business use; he borrows 150,000 secured on the factory's increased value and takes the money as drawings to purchase a personal property in Spain.

BIM45700 states that the loan is deductible against profits to the extent that the loan funds the business, or alternatively, to the extent to which the loan replaced business capital. The interest is partly disallowed because the capital account becomes overdrawn. Specifically: "The fact that part of the drawings were used to buy a property in Spain does not determine the tax treatment. An interest restriction is due because his drawings were in excess of the profits of the business available for drawing and the capital he had in the business."

There seems to be no reason why these principles should not apply to any situation where an individual replaces personal funds with borrowing on a rental property, or indeed where the capital of any business is replaced by borrowings. The individual may use the monies received from the repayment of capital from the business in any way he or she chooses.

With specific regard to rental property, an interest deduction should be available against the rental income received, provided the loan taken out does not exceed:

(a) the capital introduced to the rental business by the individual when the property started being rented out, or

(b) the maximum amount that a bank would typically lend on the security of the property (on a buy to let property, this might be 75% - 80% of the property value).

Borrowing above either limit would be in excess of the funds required to provide working capital for the business and it would therefore be difficult to argue that it met the "wholly and exclusively" test. Obviously, in order to claim any expenses as incurred "wholly and exclusively" for business purposes the property must be let at full market value.

Subject to these limits, therefore, there is potential for clients who have put personal funds into buying a rental property to refinance, release the funds originally invested for their personal use, whilst obtaining an interest deduction against rental income received.

Despite the guidance in their Manuals, you can expect individual inspectors to resist a claim for relief.

Local inspectors may challenge the interpretation despite their internal instructions. Any claim to deduct interest based on the arguments in this note should be clearly disclosed on the white space of the tax return.

01/11/2006 00:00

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