The tax year 2020/21 was the first year under which the provisions of Section 24, which have been phased in slowly since 2017, finally came into full effect. These tax reforms have substantially reduced the amount of tax relief that landlords are entitled to on property finance costs, reversing the major tax advantages previously available to property investors borrowing money through a buy-to-let mortgage.
In the guide below, we explain everything you need to know about Section 24 and how it works, as well as offering a few tips for landlords looking to reduce the impact of new rules on their finances.
What is Section 24?
Announced in 2015 and coming into full force in April 2020, Section 24 of the Finance Act 2015 restricts all income tax relief on property finance costs to the basic rate of 20%.
This represents a drastic reduction in the amount of tax relief landlords receive compared with the previous regime. Prior to the introduction of Section 24, landlords could deduct their mortgage interest payments and other property finance costs (such as mortgage admin fees, interest on loans taken out to furnish a property etc) from their rental income prior to calculating their tax bill.
As of 2020, property finance costs can no longer be deducted from rental profits before tax, with tax relief having been replaced by a tax credit based on 20% of the landlord’s mortgage interest payments.
Who is affected by the changes?
The changes apply to residential landlords if they are:
- a UK resident who lets properties in the UK or overseas
- an individual who lets residential properties in a partnership
- a trustee or beneficiary of a trust liable for UK income tax on a residential rental property
- an non-UK resident who lets residential property in the UK
Tax relief changes do not apply to holiday rentals, commercial property, or residential property owned by a registered company.
Every residential landlord with property finance costs is affected, but not everyone will have to pay more tax.
What can and can’t I deduct from my gross rental income prior to tax?
You are still allowed to deduct allowable expenses from your gross rent. A lot of tax explainers state that the changes mean landlords pay tax on all rental income earned from a property, but fail to specify that this is referring to rental profits once allowable expenses (any expense incurred ‘wholly and exclusively’ for the purposes of running a rental property) have been deducted.
Allowable expenses include:
- letting agency and property management fees
- property maintenance and repairs (but not property improvements unless they are incidental to a repair)
- utility bills and council tax
- fees for services, such as cleaning and gardening
A helpful guide for determining what constitutes an allowable expense can be found here.
Since the tax reform was phased in, relief on the following costs is now restricted and payments cannot be deducted when calculating taxable profit:
- mortgage interest
- interest on loans taken out to furnish a property
- interest on overdrafts
- administration fees and other incidental costs associated with taking out or repaying a mortgage
- alternative finance returns (for example, payments made as part of a financial arrangement that complies with religious prohibitions on lending with interest, such as a Sharia mortgage)
How does Section 24 work?
Under the new rules, landlords pay tax on all of their rental earnings (less allowable expenses) and then claim back a tax credit equivalent to 20% of annual mortgage interest.
A landlord charges £1,300pcm in rent, pays £375 in monthly mortgage interest, and incurs other expenses that average out at £300 a month.
They thus receive a taxable rental income of £12,000, while paying an annual mortgage interest of £4,500.
If they are a basic rate taxpayer, they owe £2,400 in income tax.
They are entitled to receive a tax credit of £900.
Their total tax bill is £1,500.
We will take a closer look at how this compares with the old rules shortly.
How does the change affect my portfolio?
It depends on your tax bracket and the size of your portfolio. Landlords who pay the basic rate of 20% in income tax will only see a minimal impact, as the tax credit refunds the basic rate on mortgage interest.
For landlords in the higher and additional tax brackets (as many property investors are) the impact is quite significant. If you’re a higher rate taxpayer, the previous tax regime meant that you effectively received 40% relief on your mortgage interest payments. Under the new rules, you won’t get all the tax back on your mortgage repayments and instead will only receive the 20% credit, thus doubling your tax bill.
Additionally, landlords at the top of their tax bracket could find themselves pushed into a higher band as income used to settle mortgage payments will need to be declared on their tax return. Combined with your income from other sources (such as salary or pension), your rental earnings could push your total income across the higher (£50,270) or additional (£150k) rate threshold. Landlords with multiple properties are more likely to experience a change in tax status due to the new rules.
We can see how this works in practice by returning to our example from the previous section:
With a taxable rental income of £12,000 to declare in the financial year 2021/22, a landlord who earns a salary of £42,000 per annum would be pushed over the higher-rate tax threshold of £50,270.
With a total taxable income of £54,000, the landlord would pay £1,654 in tax on the first £8,270 of their rental income and £1,492 on the next £3,730. The total bill prior to their refund is therefore £3,146.
Once the tax credit of £900 is deducted, the final bill comes to £2,246.
Prior to Section 24, the landlord would be allowed to deduct their mortgage interest payments of £4500 from their taxable income, with their overall income therefore standing at £49,500 - below the higher-rate threshold.
The taxable earnings from their rental property would be £7,500, which would be taxed at the basic rate of 20%. This would leave a total bill of £1,500, the same as in our original example.
As you can see by comparing the two examples, a basic-rate taxpayer sees no change in their final tax bill under Section 24, whereas those paying higher rates see a substantial increase in costs.
Why were the reforms introduced?
Increasing the number of UK homeowners is a longstanding political priority of the Conservative government. Primarily, the new rules were introduced to make buy-to-let property a less attractive investment prospect in order to increase the supply of housing for owner-occupiers - meaning there are greater opportunities for first-time buyers to gain a foothold on the property ladder.
A second perceived reason for the change is to professionalize the private rented sector by making the business of running a rental property too burdensome and expensive to be feasible for so-called ‘accidental’ landlords (for instance, someone who owns a property they no longer need after moving in with a spouse).
Finally, it limits the ability of higher earners to claim back significant sums in tax relief.
What can I do to reduce the impact of Section 24 on my portfolio?
The reflexive response in many quarters has been to suggest rent hikes. This is potentially counterproductive for several reasons:
- increased returns may well change your tax status, pushing you into a higher bracket and costing you more than you have gained
- the market dictates the value of your property, and if you price yourself out of the market it will take far longer to find tenants, leading to costly void periods
- to justify the higher price to prospective renters, it might be necessary to undertake costly improves to the property to increase its value
It may be that a modest adjustment in pricing is the only way to avoid incurring losses, but it is better to find alternative solutions with fewer potential ramifications for your tax status first.
Many landlords have also considered incorporating, as limited companies are not affected by Section 24 reforms. However, there is much to consider prior to forming a company and transferring ownership of your portfolio:
- limited companies might not be liable for income tax, but you would still have to pay corporation tax, plus stamp duty and capital gains tax when transferring the property to the limited company
- remortgaging fees and early repayment penalties levied by your lender
If you haven’t already, the best thing to do is discuss your portfolio with an accountant and act on their guidance. There are multiple financial planning strategies (such as changing divisions of profits in a partnership) that can be used to reduce losses, and an accountant will be able to advise on the best course of action based on your unique circumstances.
In the meantime, here are some steps you can take to mitigate the impact of Section 24 across your portfolio.
Refinance your properties
Interest rates are currently at historic lows and, as the UK emerges from the pandemic and begins its post-COVID economic recovery, they are likely to stay that way for some time. It’s therefore a great time to remortgage your property with a more competitively priced loan to reduce the amount you’re spending on mortgage interest.
You can use our Home Made Finance Hub to compare dozens of property financing options tailored to your specific needs. Simply answer the short questionnaire and begin browsing the best products for your portfolio
Reduce the size of your portfolio
It’s worth reviewing the returns of each of your properties and streamlining your investment by selling off any under-performing assets that increase your taxable income without offering much value in return.
Recent growth in house prices has been unexpectedly strong as a result of the stamp duty holiday and it’s a busy marketplace, so it’s a good time for investors looking to dispose of residential assets.
Review operating costs
The quickest and most straightforward way to recover money lost through higher taxes is to reduce your operational costs.
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