There are several key aspects to setting finance costs against tax. The following article explains how they work.

Interest Charged on Finance

The vast majority of property developers and investors will be using finance to fund purchases and improvements for their properties.

If finance is acquired and interest is charged, the amount of interest can be offset against the rental income.

The sections below describe the various scenarios where interest is likely to be charged and how it can be offset against the rental income. You will also be shown when it is not possible to offset interest.

Interest on Mortgages

One of the biggest, if not the biggest, cost that you will offset against
your rental income will be the interest that is charged against your
mortgage.

If you have a BTL mortgage, or even if you have a normal residential mortgage on an investment property, then the interest charged can be offset.

Example 1 : Offsetting BTL mortgage interest
Mr Investor has an 80% interest only BTL mortgage for £40,000
on a property that he purchased for £50,000. His annual interest charge is £3,000.
The whole £3,000 can be offset against the rental income.

More and more people are now starting to use the let-to-buy strategy. It is important to realise that you do not have to have a BTL mortgage to offset the interest.

If your previous home becomes an investment property and your mortgage provider is happy for you to rent it out (without transferring you to a BTL mortgage), then the interest on your residential mortgage can be offset.

Example 2 : Offsetting residential mortgage interest
Mr Investor buys his first home for £100,000 with a 90% residential mortgage of £90,000. 5 years later he decides to buy a larger house to accommodate his growing family. Instead of selling the existing house he decides to rent it out. He informs his existing mortgage company and they are happy for him to let the property, and they make no changes to the existing residential mortgage rate.

This means that once the new residential property becomes his PPR he can start offsetting the mortgage interest on his first home against any rental income received.

Interest on Remortgages

Just as it is possible to offset interest on an initial mortgage, it is also possible to offset interest if you decide to re-mortgage a property.

The important point to note here is that you can only offset the interest on the outstanding amount of the mortgage.

You cannot re-mortgage a property for a greater amount and offset the interest, unless the additional amount you are re-mortgaging is to be used for an investment property.

If you remortgage and use the additional capital sum to buy another property, the additional interest can be treated as an expense to offset against income from the new property.

If you remortgage and spend the proceeds on personal living expenses, you cannot offset the cost of the loan against a future CGT liability on the sale of the property. There are strict rules as to what expenses can be offset against CGT. The interest cost can only be offset against revenue.

The following three examples will illustrate when you can and when you cannot offset the interest on a re-mortgage.

When you CAN offset re-mortgage interest

In 1998 Mr Investor buys an investment property for £100,000. His mortgage provider lends him £80,000 on a fixed repayment basis at 7% per annum. His monthly interest charge is £250.

Interest rates slowly decrease, so he decides in 2003 to re-mortgage and make use of the lower rates available. The outstanding amount on the mortgage at this time is £75,000 but the house is now valued at £150,000. He re-mortgages the property for £100,000 as he wants to add an extension to the property at a cost of £25,000. The annual rate for the re-mortgage is 5%. His monthly interest rate charge is now £285 on the £100,000.

Mr Investor is able to offset the whole £285 monthly interest, as the full re-mortgage amount of £100,000 has been used for the purpose of the investment property, i.e. £75,000 for the re-mortgage and £25,000 for the improvements.

When you CANNOT offset re-mortgage interest (1)

The same example as above where Mr Investor re-mortgages for £100,000.

However, the additional £25,000 re-mortgage is to buy a brand new car for his wife to use.

Because the car is for the personal use of his wife, the interest charged on the £25,000 cannot be offset against the rental income. This is because the car is not exclusively used for the property.

This means that only 75% (i.e. the outstanding £75,000 mortgage) of the interest can be offset. Therefore he can only offset £213.75 of monthly interest against his rental income.

When you CANNOT offset re-mortgage interest (2)

Mr Investor releases equity of £10,000 from an existing property (it can be either his residence or an investment property). The equity is going to be used to fund a future property investment.

The money is stored in a personal bank account. Due to various unexpected delays, Mr Investor buys the investment property six months later. During the six months that the money was in his bank account, he had to pay interest, which accumulated to £700.

Mr Investor is not able to offset the £700 interest against his future rental income. This is because at the time the interest was charged, the £10,000 was not being used for his property investment purposes.

Interest on Deposits

If you decide to obtain finance to fund the deposit of your investment
property, then the interest charged on this deposit can also be offset
against the rental income.

The source of the finance does not matter. What matters is what the finance is used for.

This means that if you release equity out of an existing mortgage or take out a personal loan to fund the deposit then the interest can be offset against the rental income.