Section 24: What Effect are new Tax Rules Having on Landlords
It’s been five years since the controversial Section 24 changes for landlords came into force. At the time, there was plenty of concern that it would force landlords to pay more tax and could see some get out of the practice entirely. However, not all of those fears have come true and there are things you can do to manage it if you understand how it works.
Before 2017 landlords could deduct all their mortgage interest from rental income and pay tax solely on their profits. However, mortgage tax relief was gradually tapered off between 2017 and April 2020 until it was replaced altogether by Section 24’s 20% tax credit. It now means you have to pay tax on all the income you receive before claiming back mortgage interest costs, but only up to 20%, which is the basic rate of income tax.
It was introduced with three goals in mind: to stymie the private rental market, cut back on high income earners and increase the amount of housing stock available to first time buyers.
We are now coming to the end of the second full tax year in which the new rules apply, so what effect has it had?
The most immediate impact is that it increases the amount of tax you pay upfront, before being able to claim the mortgage interest back as a tax credit. For lower income earners, this might not have a massive impact aside from impacting cashflow. However, for those who have other income, it could push them into a higher tax bracket increasing the amount of overall tax they pay.
Here’s how it all works in practice.
Imagine you have a rental income of £20,000 with mortgage interest of £5,000. You’ll pay 20% income tax on that, at £4,000 or £8,000 if you’re in the higher 40% bracket. However, you can then claim back 20% of your mortgage interest payments which equates to £1,000.
So, the final amount of tax you pay depends on which income bracket you’re in for tax purposes. Those on the 20% rate will pay £3,000, while those on the 40% will pay £7,000.
The impact, therefore, is felt more keenly by people who are on the higher rate of income tax. Under the previous rules, in which you deducted interest payments from your income, you’d have been only paying tax on £15,000, which leaves you paying £6,000 (40%).
If you were on the 20% threshold, you will still be paying £3,000 – the same as under the previous rules. The only difference is you pay more upfront.
The new tax, therefore, should hit higher tax earners more severely. Using our example, they will pay an additional £1,000 on one property. Taken across a portfolio of properties, the increase would be considerable.
In theory, then, the new tax does what it sets out to do – it hits higher rate taxpayers harder while leaving lower rate payers relatively unscathed. However, it is possible to mitigate the impact of these measures.
- Reduce your portfolio: For some, a simple approach will be to reduce their rental portfolios, thereby reducing the impact on their annual tax bill.
- Transferring ownership: If your partner is in a lower tax bracket, you could try splitting your income or transferring ownership to spread income in a more tax efficient way.
- Reviewing expanses: When costs mount up in one area of your business, you may find you can reduce expenditure elsewhere. For example, you could try to manage the property yourself rather than employing a property management company, although this will take up more of your time. Alternatively, you could try to re-mortgage if you think you can find a better deal than your current one.
- Increasing rent: This will increase your income to offset your tax liability. However, it will also increase your tax burden and you will have to make sure it does not push you into the next tax bracket. At a time when the cost-of-living crisis is biting, you also want to avoid an unnecessary burden on your tenants. If they start to struggle to pay their rent, it can affect your income and add to costs if you need to take action against them.
- Switch to commercial: These changes only relate to residential income, so you can avoid them by switching to a commercial letting portfolio.
- Become a limited company: Limited companies are exempt from Section 24 so incorporating will help you avoid these changes. On the downside, it will make you eligible for capital gains tax and corporation tax.
- Use a beneficial trust: A beneficial trust is a structure which sees a legal owner hold the property in trust for a beneficiary. You can therefore retain ownership of your property while avoiding the tax changes. However, this will put you in line for capital gains tax and will require a re-mortgage. Working out whether this is more cost effective could be difficult.
The final option could be to simply sell the property, and this is exactly what many people warned might happen. Evidence about this is mixed. A report from Shawbrook Bank showed that two thirds of buy to let landlords remained positive about the future even with these changes. Data also suggests the number of buy to lets available over the last five years has risen by 18,610. However, a report from SimplyBusiness suggested 27% of landlords were planning to sell their properties in 2021, although this was also partly due to the pandemic.
Data is conflicting, but a healthy rental market shows there are still plenty of opportunities to be had. The rules affect different landlords in different ways and if you get good financial advice, you may be able to offset many of these changes. As always, those who understand the tax changes will be in the best position to mitigate the impacts.