The mismatch in UK and US taxation of rental property income

Changes to the UK taxation of rental property are increasing the taxes on an individual’s rental and for US persons, taking the UK and US tax treatment further apart.  The UK will now only allow limited tax relief for mortgage interest paid in relation to a rental property and does not allow any depreciation whereas, the US allows a deduction against income for both the mortgage interest and depreciation.

What are the UK changes and when do they come in?

In Summer Finance Bill 2015, the government introduced changes to restrict the tax deduction available for allowable finance expenses, we will focus on allowable mortgage interest payments.  The effect of the legislation would be to restrict the tax relief available to the basic rate of tax (20%) such that any taxpayers in the higher rate or additional rate tax brackets would pay additional tax on their rental income.  The provision was to be brought in on a gradual basis, applying to only 25% of the mortgage interest in the first tax year 2016/17, 50% in the next, then 75%, before finally applying to all the mortgage interest in 2020/21.

So, if your allowable mortgage interest is £10,000 and you are a 45% additional rate taxpayer, then the potential tax relief on the deduction of £4,500 will only be worth £2,000 – a tax increase of £2,500.  If your property is highly leveraged that will not just eat into your profit after tax but also your cash flow.

These rules will apply to UK residential properties as well as overseas residential properties (except those that qualify as Furnished Holiday Lets).

What are the US rules on taxation of rental property

 We will focus here primarily on the mortgage interest deductions and depreciation as the taxation of rental income is otherwise broadly similar to the UK.  For Federal tax purposes, a full deduction will be available for allowable mortgage interest paid in relation to the property.  In addition the US allows depreciation of the adjusted basis of the building and any improvements or fixtures.  Again, generally, the building would be depreciated on a straight line basis over 27.5 years for a property in the US or over 40 years for a property outside of the US.  The two deductions combined can significantly result rental profit and often result in a loss.

The quid pro quo to having depreciation is that, it is reducing your basis in the property, such that when you come to sell it the gain is much larger.  In effect the amount of depreciation you have taken over the life of the property is added back in the form of a taxable gain when the property is sold.

What is the interaction of the two and is it a problem

The deductions for US tax purposes result in a much lower taxable rental profit each year than in the UK where the deductions are not allowed or are restricted.

In the case of a UK based rental property, we have established that the UK income tax will now be higher and the taxable income will be higher than in the US.  The US would generally allow foreign tax credit for UK taxes against any tax arising on the lower profit.  However, setting exchange rates aside, when you come to sell the UK property, the taxable gain in the US will be larger due to the depreciation added back.  Those gains will be taxable at rates varying from 15 – 25%.  The UK capital gains tax rate is likely to be 28% on a disposal and you would need to hope that the UK tax due on the gain exceeded the overall US tax due on the gain and the depreciation or additional US tax may arise.

The problem will be more pronounced in the case of a UK resident taxpayer with a US rental property.  Ordinarily, under the Double Tax Agreement (Treaty) between the UK and the US, the rental profit and any gain would be primarily taxable in the US.  Looking at the rental income taxation, the effect of full mortgage interest deduction and depreciation deduction could reduce the US taxable income to nil, meaning that no US tax is payable and there is no US tax credit to offset the UK tax.  As a result UK tax is payable on the rental income.

When the property is sold any gain will be taxable in the US and the depreciation taken will also be added back and taxable.  In this case, it is the US tax accruing that will be creditable in the UK against the UK capital gains tax.

In case I have lost you, the potential effect is that income taxes on the rental income are higher and UK tax will effectively be payable on the amount of income reduced by depreciation.  On sale the same depreciation amount is taxable again in the US at a blended rate of 25%.

Let us consider a very general example:

US tax UK tax
Rental Income 25,000 25,000
Less: Mortgage interest (10,000) (10,000)*
Depreciation (12,000) NIL
Maintenance (3,000) (3,000)
Taxable Profit NIL 12,000
Tax Tax @ 45% 5,400
*Mortgage tax relief restricted 2,500
TOTAL 7,900
Disposal US Tax UK Tax
Gain on sale 200,000 200,000
Add back depreciation e.g. 10 years 120,000 NIL
Taxable gain 320,000 200,000
TAX 200k @ 20% 40,000 200k @28% 56,000
120k @ 25% 30,000 Less credit for US tax (56,000)
TOTAL 70,000 NIL

Example is approximated and general, taxes are assessed at highest rates, exchange rates ignored and the net investment income tax is not considered.

The example shows that if you just had US tax to consider after 10 years your total tax would be 70,000.  If you had UK tax alone the total would be 135,000 (10 years of 7,900 plus 56,000).  The combined UK and US tax for a US person is 149,000.  Also notable is that the mortgage interest relief reduction causes a drop in after tax profit on the property of nearly 40%.

A number of other factors can come in to play, losses carried forward on the rental, other capital losses in year of sale and exchange rates which can make projections and estimates a somewhat crystal ball affair.

In spite of these tax concerns, many clients still wish to invest in real property however, it will always be worth reviewing the tax situation to determine the impact on your return on investment and what the taxes might be on sale.  In particular taxpayers looking to rent there main home may also want to check the impact on UK and US main home exceptions.  Some will consider corporate ownership as a company can still deduct mortgage interest however that can come with additional complications particularly for US persons.

There is no doubt however, that the UK tax change makes a rental property less attractive.

David Holmes

David is a Chartered Tax Adviser and specialises in the interaction of UK and US taxes and the taxation of those who are not domiciled in the UK. He is particularly involved in the complex tax calculations that we handle relating to remittances, voluntary disclosures, US PFIC rules, Controlled Foreign Corporations and both UK and US trusts as well as completing UK and US tax returns and providing tax advice. David is a Cambridge graduate and previously worked at PwC.