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 buy-to-let 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, introduced in 2015 and fully enacted in April 2020, enforces a significant change. It limits income tax relief on property finance costs to the basic rate of 20%.
This results in a substantial reduction in tax relief for landlords compared to the previous system. Prior to Section 24, landlords could deduct mortgage interest payments and various property finance costs 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 is replaced by a 20% tax credit on the landlord’s mortgage interest payments.
How does Section 24 work?
Under the new regulations, landlords need to calculate tax on their total rental income after deducting allowable expenses. Then, they can claim a 20% tax credit on their yearly mortgage interest. Here’s an example:
- Let’s say a landlord charges £1,300 per month in rent, with monthly mortgage interest of £375 and other monthly expenses averaging £300.
- This leads to a taxable rental income of £12,000 and annual mortgage interest of £4,500.
- For a basic rate taxpayer, the income tax comes to £2,400.
- However, they can claim a tax credit of £900.
- As a result, their overall tax liability amounts to £1,500.
Who is affected by Section 24 changes?
These changes affect residential landlords falling into these categories:
- UK residents letting properties in the UK or abroad.
- Individuals letting residential properties within a partnership.
- Trustees or beneficiaries of trusts liable for UK income tax on residential rentals.
- Non-UK residents letting residential property in the UK.
It’s crucial to understand that these tax relief changes don’t apply to holiday rentals, commercial property, or residential properties owned by registered companies. While all residential landlords with property finance costs are impacted, not everyone will experience an increase in their tax liability.
How will Section 24 Affect the Buy-to-let landlord and what options do they have?
Many landlords, especially small or “accidental” ones who didn’t initially buy properties for renting, face financial challenges due to not being able to deduct finance costs as expenses. Previously, these costs were deductible, helping lower tax payments.
The changes in Section 24 have particularly impacted these landlords, leading some to consider leaving the market. Some have sold their properties, while others have had to raise rents, potentially making them less competitive.
One option for landlords is to set up a limited company. Under this structure, mortgage interest is treated as a business expense, subject to a 19% corporation tax rate, lower than the basic 20% rate, potentially resulting in tax savings. However, this involves company setup, accounting, and may require professional assistance, which can be deducted from rental profits.
Landlords should also consider capital gains tax and stamp duty when selling a property. For those looking to transfer their property portfolio to a limited company without paying CGT and Stamp Duty Land Tax, Taxaccolega offers a solution.
How will Section 24 affect my property portfolio?
The impact of these changes on landlords’ taxes depends on their income tax bracket and property portfolio size. Here’s the breakdown:
- Landlords in the basic 20% tax bracket experience minimal impact as 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 significant. Previously, higher-rate taxpayers received 40% relief on mortgage interest payments, but now they only get a 20% tax credit, effectively doubling their tax liability.
- Landlords near the upper limit of their tax bracket may be pushed into a higher tax band because mortgage income must be declared on their tax return. When combined with other income 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.
To illustrate, consider a landlord with a taxable rental income of £12,000 and 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 reveals that basic-rate taxpayers don’t see changes in their tax bill under Section 24, while higher-rate taxpayers face a significant increase in costs.
What can I do to reduce the impact of Section 24 on my portfolio?
The knee-jerk reaction to these changes has been considering rent increases, but this may have unintended consequences:
- Tax Implications: Raising rents might push you into a higher tax bracket, leading to increased tax liabilities that could offset your gains.
- Market Realities: Rental rates are influenced by market dynamics, setting rents too high could result in longer vacancy periods, increasing costs.
- Property Upgrades: To justify higher rents, you may need to invest in property improvements, incurring additional expenses.
While modest rent adjustments might be needed to avoid losses, it’s wise to explore solutions that don’t significantly impact your tax status.
Some landlords have explored incorporating as limited companies, not subject to Section 24 reforms. However, this move has considerations:
- Limited companies may face corporation tax, stamp duty, and capital gains tax when transferring property ownership.
- You might incur remortgaging fees and early repayment penalties from your lender.
If not already done, consult an accountant for tailored financial guidance based on your circumstances. They can suggest strategies like profit division adjustments within partnerships to mitigate losses.
- Refinance Properties: Consider refinancing properties with competitive loans to reduce mortgage interest costs due to low interest rates.
- Portfolio Review: Evaluate each property’s performance and consider selling underperforming assets that increase taxable income without delivering value. The current housing market is active, making it a favorable time to divest residential assets.
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