Since the introduction of Section 24, which restricted buy-to-let mortgage tax relief five years ago, the impact on landlords and the rental market has unfolded. This article assesses whether the anticipated outcomes, such as increased rents, a surge in buy-to-let companies, and landlords selling their properties, have materialized.
Section 24, commonly referred to as the ‘tenant tax’, enforces a change in how landlords can claim tax relief on mortgage interest and financing costs. Under this regulation, landlords can only claim relief at the basic rate of tax, even if they are higher-rate taxpayers.
This shift has significant implications for landlords, especially those already in the higher-rate tax bracket. It may also push some landlords who currently fall under the basic rate into the higher-rate tax category. There is a growing concern that this additional tax burden could prompt many landlords to consider selling their properties. This potential trend towards selling could, in turn, lead to a shortage of available rental properties, hence the ‘tenant tax’ nickname.
To understand how Section 24 operates and its potential impact, read on.
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.
Why was Section 24 implemented?
Section 24, often referred to as the tenant tax, was implemented by George Osborne during his tenure as chancellor in David Cameron’s government. The rationale behind Section 24 was rooted in addressing what was perceived as an inequity in the tax system.
Osborne argued that it was unjust for landlords to enjoy tax relief on their mortgage interest payments while owner-occupiers did not receive similar benefits. He pointed out that buy-to-let landlords had a significant advantage in the housing market due to their ability to deduct mortgage interest from their income, a privilege not available to homebuyers.
One of the key objectives of these changes was to curtail the demand from landlords, with the expectation that this would create a more favorable environment for first-time buyers to enter the property market. This move was aimed at rebalancing the housing market and addressing perceived inequalities in taxation.
Section 24 phase-in
The changes related to Section 24, also known as the tenant tax, were introduced in four stages starting from April 2017, with full enforcement taking effect in April 2021. Here’s a breakdown of these stages:
- 2017/18 tax year: Landlords could only deduct 75% (rather than 100%) of their finance costs at the higher-rate, with the remaining 25% deducted at the basic rate.
- 2018/19 tax year: The deduction for finance costs at the higher-rate was reduced to 50%.
- 2019/20 tax year: Only 25% of finance costs were tax-deductible at the higher-rate.
- 2020/21 tax year: Landlords could only claim basic rate deductions, but 20% of finance charges could still be offset against tax.
Finance costs primarily include mortgage interest, although they can also encompass mortgage fees and interest on loans taken out for property furnishing or refurbishment. It’s important to note that other expenses, such as maintenance costs, remain eligible for tax offset.
How does Section 24 work?
Before 2017, landlords could subtract their entire finance costs from their rental income when calculating taxable income. However, this has changed, and landlords are now taxed on their property income before accounting for finance costs.
For example, consider Fred, a landlord who receives income A from his job annually and income B from his rental property. His total income is A+B. Fred also has mortgage costs (C) and annual property maintenance expenses (D).
Previously, his taxable income was A + (B – (C + D)). However, with Section 24 fully in effect after 2021, his taxable income is simply calculated as A + B – D.
There may be a 20% tax reduction available, as explained earlier, based on the lower of finance costs, property business profits, and adjusted total income.
How does Section 24 Affect Landlords?
The impact of Section 24, also known as the tenant tax, is being acutely felt by landlords, particularly those who were already higher-rate taxpayers. However, an equally concerning aspect is the effect on landlords who were previously basic-rate taxpayers and are now pushed into the higher-rate tax bracket due to the changes in how mortgage interest is treated for tax purposes.
Previously, mortgage interest was deductible from rental income for tax calculation purposes. Under the new system, this deduction is no longer applicable, potentially resulting in landlords facing higher tax brackets when combining their rental income with other sources of income.
Landlords are undeniably apprehensive about these changes. A survey conducted by Simple Landlords revealed that 47% of landlords have altered their investment strategies in response to these tax changes, with 6% considering or already carrying out the sale of their properties. Additionally, a survey by the Residential Landlords Association found that 25% of landlords are planning to sell one or more of their properties in the coming year.
The consequences of Section 24 are expected to contribute to rental shortages, particularly in high-demand areas like London. According to Rightmove, there has been a 33% reduction in the number of rental properties available in the capital over the past two years. It’s important to note that Section 24 is not the sole factor driving this trend. Landlords are also contending with additional stamp duty costs and higher mortgage rates compared to the past. Additionally, changes to the eviction process, such as the abolition of no-fault evictions, have further complicated the landscape for landlords.
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.
A landlords’ tax example under Section 24
In this example, Section 24, fully implemented since 2021, eliminates the ability to deduct mortgage finance costs, although a 20% basic rate deduction may be applicable, as explained below.
Fred still earns £42,000 from his job and £20,000 from his rental property. For simplicity, we haven’t considered any tax already deducted from his employment income.
He pays £9,000 for his mortgage and £1,000 for maintenance, without any unused finance costs carried forward.
His taxable income is now calculated by adding his salary to his rental income and subtracting ONLY his maintenance costs (as mortgage finance costs are no longer deductible):
(£20,000 – £1,000 = £19,000) + £42,000 = £61,000
Fred pays zero tax on the first £12,570 of his income due to his personal tax allowance (2022/23).
He pays 20% tax on the next £37,699 within the basic 20% tax band.
Additionally, he pays 40% tax on the final £10,731 of his income, crossing into the higher tax band applied to income over £50,270.
Finance costs (with no brought forward) are lower than property profits and adjusted net income, enabling a 20% tax reduction based on the £9,000 finance costs. This results in an additional relief of £1,800, reducing the total tax payable from £11,832.20 to £10,032.20.
Fred’s final tax bill under Section 24 is as follows: £61,000 Gross income
- £12,570 @ 0% (falls under Personal Tax Allowance)
- £37,699 @ 20% Basic rate tax = £7,539.80
- £10,731 @ 40% Higher rate tax = £4,292.40
Total tax payable = £11,832.20
Less relief for finance costs: £9,000 @ 20% = £1,800
Final tax payable = £10,032.20
The outcome is that Fred must pay an additional £1,800 in tax compared to the pre-Section 24 era, despite his unchanged salary and rental income.
Furthermore, Fred now falls into a higher tax bracket, potentially impacting him as his employment income increases in the future.
The implementation of Section 24 carries additional drawbacks, including the possibility of child benefit clawback through the high-income child benefit charge if income exceeds £50,000.
These changes have proven particularly costly for landlords with just one or two properties, exemplified by Fred, as they are more susceptible to being pushed into the higher tax bracket.