Rental Income and a Family Loan

JamienSurrey

My wife's folks want to buy our house, but not move in for a few years until they are fully retired. So they would rent it out in the meantime.

We would then move and buy another place. Our folks don't have the full amount to buy the house so would need a mortgage. As they cannot get a mortgage (due to age and being partially retired), I will keep the house in our name and change our mortgage to a buy to let.

In numbers as an example:

House price is £175k

Current Mortgage is £120k

Folks will give (loan) us £75k

New buy to let mortage £100k

So we will take out the £55k equity to buy our new house.

For tax purposes what is the best way to account for the rental income? As we propose that all the rental income net of the buy to let mortgage should all go to our folks because we have extracted our equity.

Can we draw up a loan agreement (on the £75k) between ourselves and our folks that matches the loan interest repayments to the net income. I.e. we recognise no income, so pay no tax. So our folks recognise the income and pay tax at their end? Or is there another way?

I am a bit unsure of this, as our tax return would look odd, having rental income and expenses netting to nil exactly.

Thanks!

nomunnofun

I think that this could turn out to be inordinately complicated. I can think of no way to make your folks liable to income tax - on what income would they be taxed? Could this be the loan interest?

JamienSurrey

Sorry, may have over complicated things on the first post.

The house would be rented to an external third party with no connection to us.

Lets say the tenants pay annual rent of 10k and the buy to let mortgage is £6k, can we not fix our folks loan interest to be £4k, so our net income is nil, but our folks net income is £4k?

In that scenario we have pay no tax and our folks pay tax on the £4k?

Does that work?

Thanks

nomunnofun

I think I am getting closer to understanding but not completely.

The buy to let mortgage is in your name and the interest can be offset against the rental income from your former home. That is fine. The position appears to be that you will pay interest on a further loan from your parents. You will claim relief against your rental income and your parents will have to declare the same interest to HMRC? The tax that you save will equal the tax that they pay.

Let's say the interest rate is 5% - you pay £3750 and save tax of £750. They receive interest of £3750 and have a tax bill of £750. Why not just pay them a rate of 4% (£3000) and keep the loan interest situation out of the tax system for both you and your parents altogether?

JamienSurrey

Yep, that's correct, I will claim relief on the family loan interest payments and the folks will pay tax on the income of this.

The numbers are slightly larger than the example, so tax will be liable.

Thanks

nomunnofun

And, in my view, there would be little point in the scenario as it is revenue neutral - they pay what you save. You don't claim the interest against your rental - they don't pay the tax on the interest.

I am not sure, where there is no tax saving, that the formal drawing up of a loan deed, the declaration of the interest by your folks etc is worth the endeavour. However, that is only my opinion.

JamienSurrey

I'm a higher tax rate payer and my folks are not. A loan agreement could possibly reduce the tax liability

Thanks

heretolearn_2

It's not possible for the rental income to be allocated to anyone other than the legal owner of the house, which you will still be, so whether it's worth it or not, this isn't going to happen.

JamienSurrey

I'm not proposing allocating the rental income to someone else. I'm asking if it is possible that the net rental income can equal the interest payments on a loan our folks are giving us to release all our equity from the house.

nomunnofun

of course, your folks are able to charge whatever interest that they see fit on the loan, even if this means that the property 'profit' is NIL or is negative.

With my (ex) HMRC hat on I would say that the chances of your SA return being reviewed would be increased and I would certainly want to see formal documentation regarding the loan and interest rate payable etc.

I still do not really see the benefits overall though. It is a bit like someone whose profits mean that he pays £2000 at 40% tax i.e. an additional £400 and decides to incur expenditure of £2000 to prevent paying that £400. Still, its not my decision to make.

jimmo

If you will end up paying your in-laws more interest than you would have to pay to a bank I really think you need professional help with this one.

1) Interest payable to your in-laws.

You seem to vulnerable to attack from HMRC on 2 fronts.

A) The Ramsay principle.

This is well known amongst tax professionals and established, in the courts, that a series of artificial transactions, whose sole purpose was to save tax, could be ignored.

Under the Ramsay principle any interest you pay to your in-laws would not be allowable against your letting income (at 40%) but would also not be chargeable as income in your in-laws’ tax liability (at 20%). Unfortunately I seem to be having trouble with the HMRC website and can’t post a totally relevant link but this one explains the general principle.

http://www.hmrc.gov.uk/manuals/nimmanual/NIM04011.htm

Interest at more than a commercial rate.

Your tax relief would be restricted to the commercial rate but your in-laws would still be chargeable on the full amount they received. See (2) here.

http://www.legislation.gov.uk/ukpga/2007/3/section/384

2) Capital Gains Tax.

When you move out of your current home you will potentially become liable to Capital Gains Tax when you eventually sell it. You will certainly have 3 years, from the date you move out, to sell but anything longer than 3 years could be problematical.

http://www.hmrc.gov.uk/helpsheets/hs283.pdf

Those are the potential problems I reckon I know what I am talking about but, from peripheral knowledge, are you happy that you can get a BTL mortgage where the VTL is 100%?

Alternatively are you happy that you will get a residential mortgage on your new home when your deposit is, in reality, a loan from your in-laws?