What's the real impact of Section 24 on HMO profits, and are there any clever ways to legally mitigate it for a small portfolio (2-3 HMOs) without setting up a huge company structure?
Quick Answer
Section 24 removed the ability for individual landlords to deduct mortgage interest, impacting HMO profitability significantly. Strategies like using a limited company or commercial finance can mitigate this, but involve trade-offs in setup complexity and costs.
Section 24 of the Finance (No. 2) Act 2015, fully phased in by April 2020, profoundly altered the tax treatment of finance costs for individual residential landlords in the UK. Prior to its implementation, landlords could deduct 100% of their mortgage interest and other finance costs from their rental income before calculating their tax liability. Now, this deduction is completely removed, replaced instead by a basic rate tax credit equivalent to 20% of their finance costs. This shift primarily impacts individual landlords who are higher or additional rate taxpayers, as it effectively taxes their gross rental income, while only offering a partial credit for a significant business expense.
For example, an individual landlord with an annual rental income of £50,000 and £20,000 in mortgage interest would previously have been taxed on £30,000. Under Section 24, they are now taxed on the full £50,000 rental income, with a 20% credit on the £20,000 interest (£4,000). If this landlord is a higher-rate taxpayer, paying 42% income tax from April 2027, their tax bill on £50,000 would be £21,000, reduced by the £4,000 credit, resulting in a net tax of £17,000. Prior to Section 24, they would have paid 42% on £30,000, which is £12,600. This represents a substantial increase in their tax liability, directly reducing the profitability of their HMO portfolio. The core issue is that it effectively pushes some basic-rate taxpayers into the higher-rate bracket due to the increased taxable income, exacerbating the impact.
### How Does Section 24 Specifically Affect HMOs for Individual Landlords?
Section 24 has a particularly pronounced impact on HMOs due to their typically higher financing requirements and often higher gross rental income compared to single-let properties. HMO properties frequently involve larger purchase prices or significant refurbishment costs, leading to larger mortgages and consequently, higher interest payments. While HMOs generally yield higher rental income, Section 24's mechanism means that this higher gross income is disproportionately taxed, as the associated higher interest costs are no longer fully deductible.
Consider an individual landlord with two HMOs generating a combined rental income of £100,000 annually. Their total mortgage interest payments are £40,000 per year. Under the old system, a higher-rate taxpayer (42% from April 2027) would be taxed on £60,000 (£100,000 - £40,000), paying £25,200 in income tax. Under Section 24, they are taxed on the full £100,000, incurring a £42,000 tax liability, which is then reduced by a 20% tax credit on the £40,000 interest, amounting to £8,000. Their net tax bill becomes £34,000. This is an increase of £8,800 annually, demonstrating how Section 24 erodes a significant portion of what was previously considered net profit. The effective tax rate on their actual profit (rental income minus interest) significantly increases, making HMO investments less attractive for highly geared individual investors.
### Are There Legal Ways to Mitigate Section 24 for a Small Portfolio?
Yes, there are several legal strategies individual landlords can explore to mitigate the impact of Section 24, even for a small portfolio of 2-3 HMOs, without necessarily resorting to complex corporate structures initially. The most common and direct approach for many is operating within a limited company structure. Although this involves forming a legal entity, it's generally straightforward for property investment and is not considered a 'huge company structure' in the traditional sense, especially given its specific tax advantages.
Under a limited company structure, mortgage interest and other finance costs remain fully deductible against rental income when calculating profits. The company then pays Corporation Tax on its profits. For profits under £50,000, the small profits rate of Corporation Tax is 19%. Profits between £50,000 and £250,000 are subject to marginal relief, and profits above £250,000 are taxed at 25%. This contrasts sharply with individual income tax rates which can reach 42% or 47% from April 2027. This difference in tax rates, combined with full interest deductibility, makes limited company ownership a compelling mitigation strategy for growing portfolios. For instance, a company with £100,000 rental income and £40,000 interest would pay Corporation Tax on £60,000 at the marginal rate, typically far less than the £34,000 personal income tax for a higher-rate taxpayer in the previous example.
Another strategy involves exploring commercial or mixed-use financing options. If an HMO property has any element of commercial use, such as a shop on the ground floor with flats above, it can often be financed with a commercial mortgage. Commercial mortgage interest is typically still fully deductible as a business expense, even for individual landlords, because HMRC views commercial property as a trading business, distinct from residential property investment under Section 24. It is important to confirm the specific property classification and finance terms with lenders and tax advisors, as not all HMOs qualify as mixed-use, and interpretation can vary. The Stamp Duty Land Tax (SDLT) treatment for mixed-use properties is also more favourable, using commercial rates (£0-£150k at 0%, £150k-£250k at 2%, >£250k at 5%), which can significantly reduce acquisition costs compared to the residential surcharge of 5% on top of base residential rates for buy-to-let properties. This SDLT saving can be substantial for an acquisition over £250,000.
Optimising property ownership by transferring properties to a lower-earning spouse or civil partner, if applicable, can also reduce the overall household tax burden. If one partner is a basic-rate taxpayer (22% from April 2027) while the other is a higher-rate taxpayer, transferring a share of the property or rental income to the basic-rate earner can utilise their personal allowance and lower tax band more efficiently. However, this may incur Capital Gains Tax (CGT) and Stamp Duty Land Tax (SDLT) implications on the transfer itself, depending on whether it's a gift or a sale, and if there's an outstanding mortgage. Professional advice is essential before attempting such a transfer. The annual exempt amount for CGT is £3,000 from April 2026/27, meaning gains above this threshold would be taxed at 18% for basic rate taxpayers or 24% for higher rate taxpayers, which could be a prohibitive cost for transfers of significant value.
Finally, for properties with high mortgage interest relative to rental income, considering a reduction in borrowing through capital repayment can also mitigate Section 24. While reducing debt impacts cash flow, it also lowers the finance costs that are subject to the 20% tax credit limitation. This makes the remaining finance costs more efficient from a tax perspective and reduces overall taxable income that is subject to higher rates. However, this is a capital allocation decision that must be weighed against alternative investment opportunities and liquidity requirements. A strategy focused on increasing rental income through property refurbishment and rent optimisation, without increasing debt, also improves the profitability ratio against fixed finance costs.
### Benefits of a Limited Company Structure
The primary benefit of a limited company structure for HMO portfolios is the full deductibility of mortgage interest and other finance costs against rental income. This means the company's taxable profit is truly reflective of its net operating income before Corporation Tax. Additionally, the Corporation Tax rates (19% for profits under £50,000, 25% for profits over £250,000) are generally lower than individual higher and additional income tax rates (42% and 47% from April 2027). This allows profits to be retained within the company and reinvested in the portfolio at a lower tax cost, fostering faster growth. For example, if a limited company generates £60,000 in taxable profit, it pays £11,400 in Corporation Tax (19%). If the same profit were earned by an individual higher rate taxpayer, they would pay £25,200. This difference of £13,800 is a significant amount that can be reinvested into acquiring more properties or undertaking necessary refurbishments without further personal taxation.
Also, when profits are distributed from the company to shareholders, they are typically paid as dividends, which are taxed differently from income. While dividend tax rates apply (0% up to annual allowance, then 8.75% basic, 33.75% higher, 39.35% additional), careful planning can optimise extraction. The company structure also offers limited liability protection, separating personal assets from business liabilities, which can be a valuable consideration for property investors.
### Drawbacks and Considerations for Limited Companies
Transitioning to a limited company is not without its drawbacks. The most significant hurdle for existing portfolios is the 'incorporation relief' issue. Transferring properties from personal ownership into a limited company is generally treated as a sale, triggering Capital Gains Tax (CGT) on any capital appreciation and Stamp Duty Land Tax (SDLT) on the market value of the property. For a £300,000 HMO with £100,000 capital gain, a higher-rate taxpayer could face a CGT bill of £24,000 (24% of £100,000 minus the £3,000 annual exempt amount). Additionally, SDLT would be payable again, at the residential investor surcharge rate, adding another significant cost. The 5% investor surcharge applies on top of the base rates, meaning a £300,000 property transfer could incur SDLT of 10% on the portion between £250k and £300k, and 7% on the portion between £125k and £250k, plus 5% on the first £125k. This can make incorporation of existing properties financially unviable unless specific conditions for incorporation relief (e.g., 'business' status) are met, which is rare for small portfolios.
There are also ongoing administrative burdens, including filing annual accounts with Companies House, Corporation Tax returns with HMRC, and potentially higher mortgage interest rates for limited company buy-to-let products compared to personal ones. While these additional administrative tasks are manageable, they represent extra costs and time commitments. For a portfolio of 2-3 HMOs, these costs may be outweighed by the tax benefits, but each case requires individual financial modelling. Lender options for limited company mortgages may also be more restricted compared to individual BTL mortgages, and rates can sometimes be slightly higher.
### Investor Rule of Thumb
For HMO investors, carefully model your post-Section 24 tax liability as an individual, and then compare it with the potential Corporation Tax and associated costs of operating through a limited company, especially for new acquisitions.
### What This Means For You
Understanding the nuanced impact of Section 24 and the various mitigation strategies is critical for optimising your HMO portfolio's profitability. Most landlords don't lose money because they misunderstand tax rules, they lose money because they don't apply bespoke tax planning to their specific portfolio. If you want to know how to legally optimise your portfolio's tax efficiency and ensure your HMOs generate sustainable profits, this is exactly what we analyse inside Property Legacy Education.
Steven's Take
Section 24 fundamentally changed the game for individual residential landlords, particularly those with geared portfolios like HMOs. My own portfolio was built with tax efficiency as a core principle from the outset. For a small HMO portfolio, say 2-3 properties, the impact of Section 24 can be significant, potentially eroding a substantial portion of your net income if you're a higher-rate taxpayer. The key here is proactive planning, not reactive adjustments. While incorporating existing properties can be costly due to CGT and SDLT, setting up a limited company for new acquisitions is almost a default strategy for many investors today, especially given the current Corporation Tax rates and the ability to deduct all finance costs. Don't shy away from professional advice; the cost of a good tax advisor is often dwarfed by the potential tax savings.
What You Can Do Next
1. Calculate Your Current Section 24 Impact: Use HMRC's guidance or an online calculator to precisely determine your current income tax liability on your HMO profits under Section 24. This will give you a baseline figure for comparison.
2. Model Limited Company Profitability: Engage with a property tax accountant to model your potential profits and Corporation Tax liability if your HMOs were held within a limited company structure. Request a projection for both immediate profits and retained earnings reinvestment.
3. Research Incorporation Costs: Obtain professional advice on the Capital Gains Tax (CGT) and Stamp Duty Land Tax (SDLT) implications of transferring any existing personally-owned HMOs into a limited company. This will help you understand the 'cost of incorporation' for your specific assets and whether it's viable.
4. Explore Commercial Finance Options: Consult with a specialist commercial mortgage broker to determine if any of your properties, or future acquisitions, could qualify for commercial or mixed-use financing, which typically allows full interest deductibility. Discuss the specific criteria and lender requirements.
5. Review Spouse/Partner Tax Position: If applicable, assess whether transferring a share of property ownership or rental income to a lower-earning spouse or civil partner could lead to tax efficiencies, considering any potential CGT or SDLT implications. Seek legal and tax advice before any transfers.
6. Conduct a Leverage Review: Evaluate the current leverage on your HMOs. Consider if a partial capital repayment makes financial sense to reduce interest costs, factoring in the opportunity cost of that capital compared to reinvestment or other uses.
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