Tax relief on mortgage interest, not payments
Most buy-to-let property investors with capital repayment mortgages (as opposed to interest-only mortgages) are surprised to learn that they cannot deduct the mortgage payments in full when working out the income from the property for tax purposes. The reason becomes clear once 2 concepts are understood.
The breakdown of a mortgage payment
The idea of a capital repayment mortgage is that over the life of the mortgage, it is gradually paid back, so that after 25 years the loan is fully repaid and the property is owned outright. Obviously interest is charged on the outstanding balance each month, so to make any progress in paying back the loan, the borrower needs to pay that month’s interest, plus an extra amount to pay off some of the original amount of the loan. This extra amount is called the capital repayment.
At the start of the mortgage the amount owed to the lender is high, so the monthly interest is high, and so the amount of the monthly payment left to pay back some of the capital is a very small part of the total payment. Apart from short-term fluctuations in interest rates, the total monthly payment tends to stay the same throughout the life of the mortgage. As the years go by the mortgage balance gradually decreases, so the interest decreases and the amount of the monthly capital repayment increases. Towards the end of the mortgage, the balance and interest are low and so most of the monthly payment can be used to pay back the initial loan amount.
The difference between a payment and an expense for tax purposes
Why does the breakdown of the mortgage payment matter, when the cost each month is the amount that leaves the bank account? Well, for accounting and tax purposes there is a big difference between a payment and an expense.
In simple terms, a payment is when you convert money into something else you own, that does not leave you any worse off overall. For example, suppose you pay £5,000 for a car. Yes, you have now got £5,000 less in the bank, but instead you have now got something else worth £5,000. Overall you are no worse off.
An expense is an event that does leave you worse off. After a year of use, that car would have lost some of its value. That is an expense, along with the petrol used and repairs carried out.
The tax system generally only gives tax relief for expenses, not payments, since it is only expenses that leave you worse off overall.
In terms of a mortgage, the capital repayment element of the monthly payment is paying off the borrower’s debt. As the debt has gone down by the same amount as the capital repayment element, there is no overall loss on that element, and so no relief is available. By contrast, the interest element of the payment has no corresponding benefit, so it is a loss which can be deducted from rental income.
Lump sum mortgage repayments
The explanations here have focused on regular monthly mortgage repayments, but they apply equally to occasional lump sums to partly repay all types of mortgages.