The tax year 2020/21 marked the full implementation of Section 24, a series of tax reforms gradually phased in since 2017. These reforms have significantly decreased the tax relief landlords can claim on property finance expenses, essentially eliminating the tax advantages that were once available to property investors using BTL mortgages.
In the guide that follows, we provide a comprehensive overview of Section 24, its functioning, and offer practical tips for landlords aiming to mitigate the financial impact of these new regulations.
What is Section 24?
Section 24 of the Finance Act 2015, which was unveiled in 2015 and took full effect in April 2020, imposes a significant change. It restricts all income tax relief on property finance costs to the basic rate of 20%.
This marks a substantial reduction in the tax relief available to landlords compared to the previous system. Before the introduction of Section 24, landlords could subtract their mortgage interest payments and various property finance costs (such as mortgage admin fees and interest on loans used for property furnishings) from their rental income before calculating their tax liability.
Starting in 2020, property finance costs can no longer be deducted from rental profits before tax. Instead, tax relief has been replaced by a tax credit equivalent to 20% of the landlord’s mortgage interest payments.
Who is affected by the changes?
These changes impact residential landlords if they fall into the following categories:
- UK residents who let properties in the UK or overseas.
- Individuals who let residential properties as part of a partnership.
- Trustees or beneficiaries of a trust that are liable for UK income tax on a residential rental property.
- Non-UK residents who let residential property in the UK.
It’s important to note that these tax relief changes do not apply to holiday rentals, commercial property, or residential properties owned by registered companies. While every residential landlord with property finance costs is affected, not everyone will see an increase in their tax liability.
How does Section 24 work?
Under the new regulations, landlords are required to pay tax on their entire rental income, accounting for allowable expenses, and then claim a 20% tax credit on their annual mortgage interest. Let’s illustrate this with an example:
- Suppose a landlord charges £1,300 per month in rent, has monthly mortgage interest of £375, and additional monthly expenses averaging £300.
- This results in a taxable rental income of £12,000 and annual mortgage interest of £4,500.
- For a basic rate taxpayer, the income tax owed amounts to £2,400.
- However, they are eligible for a tax credit of £900.
- Consequently, their total tax liability stands at £1,500.
How will Section 24 Affect the BTL property landlord and what options do they have?
Many landlords, especially small or “accidental” landlords who didn’t initially buy properties with the intention of renting them, face financial challenges due to the inability to deduct finance costs as expenses. In the past, finance costs were considered deductible expenses, allowing landlords to offset them against rental profits, resulting in lower tax payments.
Section 24’s changes have hit these landlords the hardest, leading many to consider leaving the market altogether. Some have sold their properties, while others are left with the only option of increasing rents, potentially making them less competitive.
One alternative for landlords is to incorporate a limited company. When operating a property through such a company, mortgage interest can be treated as a business expense, subject to a 19% corporation tax rate, lower than the basic 20% tax rate, providing potential tax savings.
However, this setup involves setting up the company, filing returns, preparing accounts, and may require professional expertise, incurring additional costs that can be deducted from rental profits.
Landlords must also consider the implications of capital gains tax and stamp duty when selling a property. For those interested in transferring their property portfolio into a limited company without paying CGT and Stamp Duty Land Tax, Taxaccolega offers a solution.
How does the change affect my portfolio?
The impact of these changes on landlords’ taxes depends on their income tax bracket and the extent of their property portfolio. Here’s a breakdown:
- Landlords in the basic 20% tax bracket experience minimal impact since the tax credit offsets their basic rate on mortgage interest.
- For landlords in higher or additional tax brackets, which many property investors fall into, the impact is substantial. Previously, higher-rate taxpayers received 40% relief on mortgage interest payments. Under the new rules, they only receive a 20% tax credit, effectively doubling their tax liability.
- Landlords near the upper limit of their tax bracket may get pushed into a higher tax band because income used for mortgage payments must be declared on their tax return. When combined with income from other sources like salary or pension, rental earnings could push them beyond 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 these new rules.
Illustrating this with an example:
- Suppose a landlord with a taxable rental income of £12,000 also earns a salary of £42,000 per year. This additional income pushes them over the higher-rate tax threshold. With a total taxable income of £54,000, they pay £1,654 in tax on the first £8,270 of rental income and £1,492 on the next £3,730, resulting in a total bill of £3,146 before the tax credit.
- After deducting the tax credit of £900, their final tax bill amounts to £2,246.
- Under the previous tax rules, the landlord could deduct their mortgage interest payments of £4,500 from their taxable income, keeping their overall income below the higher-rate threshold. This would result in a total bill of £1,500, as shown in the original example.
- This comparison highlights that basic-rate taxpayers don’t see changes in their tax bill under Section 24, while those paying higher rates face a significant increase in costs.
Why were the reforms introduced?
The new rules were introduced to align with the Conservative government’s goal of increasing the number of UK homeowners. They aim to make BTL less appealing as an investment, thereby boosting the housing supply for owner-occupiers, particularly benefiting first-time buyers.
Another rationale for these changes is to professionalize the private rental sector. By increasing the costs and burdens associated with managing rental properties, it discourages “accidental” landlords—those who own a property they no longer need after changes in their living arrangements.
Additionally, the rules restrict higher earners from claiming substantial tax relief, thus affecting their ability to do so.
What can I do to reduce the impact of Section 24 on my portfolio?
The knee-jerk reaction in response to these changes has been to consider raising rents, but this approach may have unintended consequences:
- Tax Implications: Increased rental income may push you into a higher tax bracket, resulting in greater tax liabilities that could outweigh your gains.
- Market Realities: Rental rates are influenced by market dynamics, and setting rents too high could lead to longer vacancy periods, increasing costs.
- Property Upgrades: To justify higher rents, you might need to invest in property improvements, incurring additional expenses.
While modest rent adjustments may be necessary to avoid losses, it’s advisable to explore alternative solutions that don’t impact your tax status significantly.
Some landlords have explored the option of incorporating as limited companies, which are not subject to Section 24 reforms. However, this move comes with considerations:
- Limited companies may be subject to corporation tax, stamp duty, and capital gains tax when transferring property ownership.
- You may face remortgaging fees and early repayment penalties from your lender.
If you haven’t already, consult with an accountant who can provide tailored financial guidance based on your specific circumstances. They can suggest strategies like profit division adjustments within partnerships to mitigate losses.
- Refinance Properties: With historically low interest rates, consider refinancing your properties with more competitive loans to reduce mortgage interest costs.
- Portfolio Review: Evaluate the performance of each property and consider selling underperforming assets that increase taxable income without delivering significant value. The current housing market is active, making it a favorable time to divest residential assets, particularly due to recent increases in house prices attributed to factors like the stamp duty holiday.
Remember, it’s essential to have a comprehensive strategy tailored to your unique financial situation, and consulting with an accountant is a prudent step to take.
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