Understanding Tax Relief on Interest and Finance Costs for Property Owners
For property owners, understanding how tax relief on interest and finance costs works is crucial for effective tax planning. However, not all property owners are treated equally, and the tax relief available depends on the type of property (residential or commercial) and the structure of the property business (unincorporated or incorporated). In this guide, we will explore the rules governing tax relief on interest and finance costs, including special considerations for mixed-use properties and mixed portfolios.
The Basics: How Tax Relief on Interest and Finance Costs Works
Tax relief on interest and finance costs is a critical aspect of property taxation. However, the way this relief is applied depends on several factors:
- Property Type: Residential vs. Commercial.
- Business Structure: Unincorporated (sole trader or partnership) vs. Incorporated (limited company).
- Use of the Property: Residential letting, commercial letting, or furnished holiday lettings.
Residential Property: The Basic Rate Tax Reduction
For residential properties, including furnished holiday accommodation from 6 April 2025, the rules differ depending on whether the landlord is operating as an unincorporated business or a company.
Unincorporated Residential Property Businesses
- Relief for interest and finance costs is provided as a basic-rate tax reduction (20%).
- The tax reduction is calculated as the lower of:
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20% of the interest and finance costs.
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20% of the property business profits.
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20% of the landlord’s adjusted net income.
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If the property business makes a loss, any unrelieved interest and finance costs are carried forward for use in future years.
Example:
Sarah, a landlord with an unincorporated property business, has £10,000 in mortgage interest for her residential property. Her taxable rental profit is £12,000, and she is a higher-rate taxpayer (40%). Her tax relief is calculated as follows:
- 20% of £10,000 = £2,000.
- This £2,000 is deducted from the tax payable on her rental profit.
Incorporated Residential Property Businesses (Property Companies)
For landlords operating through a limited company, interest and finance costs are treated like any other business expense. This means they are deducted in full when calculating the company’s taxable profit. There is no restriction to a basic-rate tax reduction.
Example:
ABC Properties Ltd, a property company, has interest costs of £15,000 on a mortgage for a residential property. These costs are deducted in full from the company’s rental income when calculating taxable profits.
Commercial Property: Full Deduction for Interest Costs
For commercial properties, the rules are much simpler. Whether the landlord is operating as an unincorporated property business or a limited company, interest and finance costs are fully deductible as business expenses.
Example:
David owns a commercial warehouse, and his annual mortgage interest is £8,000. Regardless of whether he operates as an individual or through a company, he can deduct the full £8,000 from his rental income when calculating his taxable profit.
Mixed-Use Properties: Apportioning Interest Costs
Mixed-use properties, such as a shop with a flat above it, present additional complexity because different rules apply to the residential and commercial parts of the property.
How to Apportion Interest Costs
- Interest costs must be apportioned on a “just and reasonable” basis between the residential and commercial sections.
- HMRC does not prescribe a specific method for apportionment, but common methods include:
- Floor Area: Dividing the interest cost based on the proportion of space used for residential vs. commercial purposes.
- Rental Income: Apportioning costs based on the rental income generated by each part.
- Property Value: Allocating costs based on the value of each section.
Example: Apportioning by Floor Area
James owns a three-storey property with a ground-floor shop and a two-storey flat above. His mortgage interest is £12,000 per year. The floor area of the shop is one-third of the total, while the flat is two-thirds. James can apportion his interest costs as follows:
- Shop (Commercial): £12,000 × 1/3 = £4,000 (deducted in full).
- Flat (Residential): £12,000 × 2/3 = £8,000 (relief at 20%, reducing tax by £1,600).
Choosing the Best Apportionment Method
Landlords should use the apportionment method that provides the most favorable tax outcome, provided it is reasonable. In James’s case, apportioning by floor area is beneficial because more of the interest cost is allocated to the commercial portion, which is fully deductible.
Mixed Property Portfolios: Managing Interest Costs
Landlords with mixed property portfolios (a combination of residential and commercial properties) must also apply the correct rules for each type of property.
Separate Loans for Each Property
If loans are linked to specific properties, the rules for each type of property apply without the need for apportionment.
Example: Separate Loans for Different Properties
Julia owns three residential properties and one commercial workshop:
- House 1: £12,000 interest (relief at 20%).
- House 2: £2,500 interest (relief at 20%).
- House 3: £9,000 interest (relief at 20%).
- Workshop: £3,800 interest (full deduction).
Julia’s tax relief is calculated separately for each loan, with £3,800 deducted in full for the workshop and £4,700 (20% of £23,500) deducted as a basic-rate reduction for the residential properties.
Single Loan for a Mixed Portfolio
If a landlord has a single borrowing facility for the entire property portfolio, the interest costs must be apportioned on a just and reasonable basis.
Example: Apportionment by Property Value
Jane has a mixed portfolio with seven residential properties (costing £1.5 million) and three commercial properties (costing £1 million). Her total interest cost for the year is £30,000. The interest is apportioned based on property value:
- Residential: (£1.5m / £2.5m) × £30,000 = £18,000 (relief at 20% = £3,600).
- Commercial: (£1m / £2.5m) × £30,000 = £12,000 (full deduction).
Alternatively, Jane could choose to apportion interest costs based on rental income from each type of property.
Practical Tips for Managing Interest Costs
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Maintain Clear Records: Ensure that you have records of all interest payments and that these are linked to specific properties where possible.
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Choose the Most Favorable Apportionment Method: For mixed-use properties, select the apportionment method that minimizes your tax bill.
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Consider the Benefits of Incorporation: If you have significant residential property interest costs, operating through a limited company may offer better tax relief.
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Monitor Changes in Legislation: From 6 April 2025, furnished holiday lettings will be treated as residential properties for interest relief purposes, meaning relief will be capped at the basic rate (20%).
Call to Action – Optimize Your Property Tax Relief with Merranti Accounting
Navigating the complex rules for interest and finance cost relief can be challenging, especially with mixed-use or mixed-portfolio properties. At Merranti Accounting, our experts help landlords maximize their tax savings by applying the correct rules and identifying the most advantageous strategies. Don’t leave your tax relief to chance. Let Merranti Accounting help you optimize your property business.
