Section 24, a term well-known among landlords, introduces heightened taxes that can diminish profits in the residential rental property sector. The concerns among landlords regarding these changes are palpable.
To explore the possibility of entirely avoiding Section 24 tax, let’s delve into its fundamentals. Understanding how it operates and its repercussions for landlords is crucial.
The government instituted Section 24 tax changes in 2015, culminating in full implementation by April 2020. Private landlords, particularly those in higher tax brackets, could find themselves significantly affected by these alterations.
What is Section 24?
In 2015, the then-Chancellor George Osborne implemented a significant tax policy change known as Section 24, which had a considerable impact on buy-to-let mortgages. Under this controversial regulation, rental income from properties became fully taxable. Landlords, however, retained the ability to claim back mortgage interest costs, albeit limited to the basic income tax rate of 20 percent. The implementation of these changes was phased in, starting in 2017 and reaching full effect in April 2020.
Prior to the initiation of these tax alterations in 2017, landlords had the privilege of deducting the entirety of their mortgage interest from their rental income, resulting in taxation solely on their profits. However, during the transitional period between April 2017 and April 2020, mortgage interest tax relief underwent a gradual reduction, ultimately being replaced by a 20 percent tax credit.
What is Section 24 of Income Tax Act?
Section 24 of the Income Tax Act of 1961 deals with interest payments on home loans and is categorized as “Deductions from house property income.” This section allows for tax deductions on the interest paid on your home loan.
In the broader context of the Income Tax Act, various sections offer tax exemptions for specific investments and expenses. The government recognizes the importance of homeownership and provides multiple exemptions for investments in your first home, alleviating tax burdens.
Section 24, focusing on home loans, offers exemptions for the interest payments made on these loans.
How does Section 24 work?
Section 24 represents a significant change for landlords, as it mandates that they must pay income tax on their entire rental income, with the option to claim back a maximum of 20% in tax relief.
To illustrate how this works, consider an example: Let’s assume your rental income amounts to £15,000, and your interest payments on the property amount to £5,000.
- Firstly, you will be required to pay tax on the full rental income.
- For basic rate taxpayers (taxed at 20%), this tax would amount to £3,000. For higher rate taxpayers (taxed at 40%), the tax would be £6,000.
- You can then claim back 20% of your interest payments, which is £1,000 (as £1,000 represents 20% of £5,000).
- Consequently, basic rate taxpayers would pay a total of £2,000 in tax, while higher rate taxpayers would pay £5,000 in tax.
This example illustrates that Section 24 has a more substantial impact on higher-rate taxpayers. The intention behind this is to dissuade potential landlords from entering the private rental sector.
Why was it introduced?
The Section 24 tax was implemented as part of a strategy to curb the rapid growth of the private rental sector. When it was introduced, there were concerns about a potential property “bubble” forming, which could have adverse effects on the broader economy.
The primary aim of Section 24 is to reduce the profitability of buy-to-let properties, making it less attractive for landlords and potentially leading some to exit the sector. This slowdown in the market is seen as a way to address the perceived issues associated with a rapidly expanding rental market.
Additionally, Section 24 has the effect of making property “flipping” less lucrative, discouraging this practice. As a result, fewer individuals engage in flipping properties, which, in turn, increases the supply of properties on the market. This increased supply can benefit first-time buyers, making it easier for them to enter the property market.
What can landlords do about section 24?
Landlords have been getting in contact and asking what they should be doing. Tax Policy Associates doesn’t, and can’t, provide tax advice – but it’s a fair question. Here’s a quick summary of how we see things:
Section 24 of the Finance (No. 2) Act 2015 amended the UK tax code to restrict landlords’ ability to deduct their mortgage interest costs from their taxable rental income.
Engage a qualified tax adviser, incorporate a company, and transfer your property business to that entity. This allows full deduction of mortgage interest against the company’s corporation tax. However, key considerations include:
- New Mortgage Terms: Your current lender is unlikely to transfer the existing mortgage to the new company. Obtaining a new mortgage may entail higher costs (interest and fees). Assess whether these costs outweigh the tax benefit.
- Stamp Duty: Transferring to a company may incur stamp duty up to 15%, with an additional 2% for non-residents. Retrospective partnership claims for married couples might not effectively escape stamp duty, as recent legal cases highlight.
- Capital Gains Tax (CGT): Property transfer to the company may trigger CGT. While CGT incorporation relief is possible, proving a “business” to HMRC can be challenging. Complex structures may jeopardize incorporation relief, resulting in higher overall taxes.
- Double Taxation: The company incurs tax on profits with a deduction for interest costs. When the company distributes profits to you (dividends, wages, or capital gains), a second level of tax applies. Thorough calculations are essential to account for this double taxation scenario.
2. Don’t Incorporate
Maintain your current approach, accepting the expense of non-deductible interest under Section 24.
Alternatively, consider reducing leverage to avoid incurring an after-tax loss, recognizing that this requires deploying additional capital.
It’s possible that neither of the initial two options is viable, as Section 24 renders your rental business financially impractical, consistent with Osborne’s intent.
In such a scenario, selling up might be necessary. It’s not an acknowledgment of failure but a recognition that investors must adjust to changing circumstances.
What is the fourth choice?
There isn’t a one-size-fits-all solution.
Trusts, LLPs, offshore arrangements – not only are they likely to fail when challenged, but the consequences could be far worse than doing nothing at all. Potential six-figure sums in SDLT plus CGT, coupled with intricate structures, can lead to complex and expensive additional tax implications.
Whether you’re a multinational executing a £10bn M&A transaction or a landlord contemplating incorporating a one-property business, the crucial tax question remains constant: “How much do I gain if this succeeds, and how much do I stand to lose if it goes awry?”
Who’s Affected by Section 24 and Its Tax Relief Changes?
The impact of these tax relief rules extends broadly, affecting individual landlords in the private rented sector. This includes various scenarios:
- UK-resident landlords renting out properties in the UK or abroad.
- Non-UK resident landlords with UK rental properties.
- Landlords using partnerships to let properties.
- Landlords operating as limited liability companies, subject to a distinct tax system, allowing them to declare rental income after accounting for mortgage costs.
The government’s policy paper on finance cost relief estimated that only a fifth of individual landlords would experience reduced relief under the new regulations. Notably, higher-earning landlords shoulder the primary impact of these changes.
Consequently, landlords must now pay tax on their gross rental income, potentially pushing some into higher tax brackets.
Government Response to the Petition for Full Tax Relief Reinstatement
The impact of Section 24 on the rental property market prompted a petition signed by many landlords. This petition highlights the consequences of Section 24 on the rental stock and the potential benefits of restoring full relief.
Signatories, including Marc von Grundherr, Director of Benham and Reeves, emphasize these changes’ significant influence. According to a landlord survey, 73% of those contemplating exiting the sector would reconsider if Section 24 changes were reversed.
In response, the government remains firm in setting mortgage interest relief against rental income at the basic tax rate. Their aim is to maintain fairness within the income tax system and avoid granting landlords advantages beyond what homeowners receive.
While the petition faces further challenges, it could trigger a parliamentary debate if it reaches 100,000 signatures.
Understanding the Change in Interest Relief
Before the tax year 2016/17, individual residential landlords paid taxes based on their net rental profits. This calculation involved deducting eligible property expenses and mortgage interest from gross rental income.
Due to the gradual implementation of interest rate relief restrictions, starting in the tax year 2016/17 and fully in effect by the tax year 2020/21, landlords can no longer deduct mortgage interest as an expense. Instead, they receive a 20% tax credit against their tax liability.
In practice, this means that landlords may face a tax bill higher than their net rental income, resulting in a loss after tax. In some cases, the effective tax rate on net rental profits can soar to 220%.
Mitigating Section 24’s Impact on Your Portfolio
To alleviate Section 24’s impact and manage changes in interest relief, landlords have various options beyond raising rent, which may not always be effective:
- Market Dynamics: Rental rates are market-driven. Overpricing can lead to longer vacancies and financial losses. Aligning rent with market rates is crucial.
- Property Upgrades: Justifying higher rent with property improvements can lower your property’s value and tax bracket.
Alternative strategies include reviewing operating expenses, self-managing properties, exploring remortgaging, and diversifying into commercial property investments. Consultation with financial and property experts is advisable to tailor solutions to individual circumstances.
Is there a way around the changes?
Yes! Landlords have the option to establish a limited company to purchase a property or transfer ownership of an existing one to that company.
The current corporation tax rate stands at 19%, and it is slated to decrease to 17% in 2020. This rate is significantly lower than the 40% higher rate and the 45% additional rate of personal income tax. As a business expense, mortgage interest can be entirely offset against tax when operating as a limited company.
However, this approach may not be suitable for everyone. When transferring a property to a company, you are likely to incur stamp duty and capital gains tax since the legal ownership of the property changes hands. Additionally, when you wish to withdraw money from the company (unless you plan to reinvest all of it), you will be subject to further taxation. The first £2,000 of dividends can be received tax-free, but subsequent amounts are taxed at rates ranging from 7.5% to 38.1%, depending on your tax band.
Securing a mortgage as a company might pose some challenges, although an increasing number of lenders are now offering limited company buy-to-let mortgages. If you opt for the limited company route, it is advisable to engage an accountant who can assist in determining the most tax-efficient method for managing your income.