How to boost your buy-to-let profits with a rarely used tax tip

To buy the new property, I was able to get a mortgage for £131,000, and I put a further £100,000 towards it from my savings. My mother also agreed to loan me the amount of £75,000, with interest set at £300 per month.

To ensure her loan was protected, I drafted a contract confirming that the loan was secured against the flat in Leith, and the contract was held by the same solicitor who held the deeds for the flat.

I have bank statements confirming regular payments of £300 to my mother’s account every month.

HMRC has accepted that the loan was secured against the Leith flat. However, it said that because the £75,000 was put towards the purchase of the Bathgate house, the interest payments cannot be offset against the rental income when determining the tax payable, as the loan is not an “allowable expense”.

It said this is because the loan amount has not been used “wholly” for my rental business.

Surely this must be wrong, as I could not have retained the Leith flat for rental purposes without the mortgage from my mother?

Is HMRC correct in denying the interest payments as an allowable expense?

– Marc

Dear Marc,

You are not the only person who has contacted me about this issue. You can find a similar question posted recently on the HMRC Community Forum, and HMRC’s response was along similar lines.

This reply is consistent with the general view of HMRC, although I think it could helpfully have been expanded.

To explain what is going on, I need to give you some of the history. Before 1994, tax relief on loan interest on let property was only allowed where the loan was taken out and the money used exclusively to acquire or improve the let property.

However, in 1994, the law changed and property renting became treated for most tax purposes as a business. This included the rules on interest relief, and it became part of the property letting accounts rather than comprising a separate claim on the tax return.

The Inland Revenue, as was, published some detailed guidelines in their tax manuals here which included some helpful examples. I remember it well because I was played a part in having this guidance issued.

How loan interest can qualify for tax relief

Amongst other things, it established the principle that interest paid on replacement loans would qualify for tax relief.

The second example in this release also confirmed that if an asset were taken on and introduced to the property business, surplus capital in the business, even of the same amount, could then be extracted and used for a non-business purpose with interest on the replacement loan qualifying as a business expense.

Likewise, further surplus capital could be withdrawn up to the value of the property at the time it was first let, so long as the proprietor’s account did not go overdrawn.

A helpful way of looking at this is by considering the business balance sheet in the same way as the examples.

On the assets side, you have the property which for this purpose should be stated at the market value when it was first introduced to the business and let. In liabilities, this has been financed by the business loans together with your capital account.

Simply put, you can both introduce and withdraw capital with the loan interest qualifying for tax relief as long as you retain a positive amount, being the difference between the property value when you first let it, and the overall debt. The same principle applies to any business.

The loan ‘loophole’

For example, you could potentially replace a non-qualifying mortgage on your home with a qualifying loan by refinancing it through your business accounts.

The security used, which can include your home, need not be an issue, as explained here. This can be very tax efficient, but I refuse to call it a “loophole” because it is simply the way the law works, as endorsed by HMRC here.

The question arising from the guidance was to what extent it was necessary for the property owner to demonstrate that the loan had been introduced to the property business before the surplus capital was withdrawn. 

I generally advised clients with let properties to set up a dedicated property bank account through which all property related transactions went, including capital additions and any withdrawals.

I saw that as a safe way to show how the funds flowed. It is also helpful to produce some simple accounts for your business, including a balance sheet to show the capital position, which demonstrate the introduction of debt in a similar way to the guidance.

There is some flexibility in this, as explained in the HMRC manuals here. This includes an important quote from a court judgment:

“We take the view that the question whether interest was paid for the purposes of a trade must depend on whether the loan, on which the interest was paid, was itself incurred for the purposes of that trade. It does not necessarily follow that the purposes of the loan can be ascertained by looking at the immediate use to which the borrower applies the money.

“The question is one of fact to be decided on the evidence available in each case.”

There is additional support for this more flexible approach here.

The second example shows a private asset and existing separate loan being introduced to the business with interest on the loan qualifying. The example is of a car but that does not matter because the manual explains that the same principles for a car introduced to a trade, also apply to a property business.

More recently, HMRC decided to publish some guidance headed: “Work out your rental income when you let property”. 

This was no doubt intended to be helpful but unfortunately it included this comment: “If you increase your mortgage loan on your buy-to-let property you may be able to treat interest on the additional loan as a revenue expense, or get relief against income tax as long as the additional loan is wholly and exclusively for the purposes of the letting business”.

In my view, this oversimplifies the true position. My concern is that it may have been read by some tax inspectors as overriding the detailed guidance noted above and which remains the primary source.

Back to your circumstances.

You had no debt on your flat when you lived there, but subsequently took on debt when you bought your new home in Bathgate. This was in June 2008, nine months before you started letting your flat in April 2009. As you say, you could not have retained the flat and started your property letting business without the £75,000 loan from your mother.

In effect, this represented funds you raised in anticipation of starting your property business. Arguably this debt transferred to your property business in April 2009. Whether that is what happened, however, will depend critically on the supporting evidence available, such as in your business accounts.

I cannot give you a definitive answer to your question because so much depends on the detailed fact pattern. I have not seen the supporting documents nor the correspondence with HMRC. Nevertheless, I think you have reasonable grounds for claiming relief for loan for interest on the £75,000.

For added support, I decided to check my view with tax consultant Lee Sharpe (not the footballer) who advises in this area and who was more positive.

He believes that you have strong grounds for claiming relief and would be happy to help you do so if you wished. Indeed, he went further and suggested that the starting point should not be whether you can claim interest relief only on the loan for £75,000, but whether you might be able to claim relief on part of the £131,000 loan as well.

Despite that, I anticipate that the inspector may need some persuading to accept this analysis.

One of the best ways of doing so is with reference to the HMRC manuals. The manuals are not the law, but they are the instructions which inspectors are expected to follow.

I suggest that you respond by explaining your claim using the manual references I have set out, in particular this one and this one together with any evidence that connects your loan to the property business.

In the meantime, you might consider refinancing the existing loan(s) through your property business to make sure more interest qualifies in future, as described above. 

Finally, remember that there is a part restriction at 20pc basic-rate income tax relief for most residential lettings.

Mike Warburton was previously a tax director with accountants Grant Thornton and is now retired. His columns should not be taken as advice, or as a personal recommendation, but as a starting point for readers to undertake their own further research.