How does Section 24 impact HMO mortgage profits?

Section 24 of the Finance (No. 2) Act 2015 introduced significant changes to how residential landlords calculate their taxable rental income. For landlords of Houses in Multiple Occupation (HMOs), understanding this legislation is crucial, as the restriction on finance cost relief fundamentally alters the profitability calculation, particularly for those with high levels of borrowing or those who are higher or additional rate taxpayers.

How Does Section 24 Impact HMO Mortgage Profits for UK Landlords?

The profitability of any rental investment hinges on the yield achieved versus the total operating costs, with taxation being one of the largest variables. Since its full implementation in April 2020, Section 24—often termed the ‘tenant tax’—has reshaped the landscape for individual landlords, directly influencing the net returns derived from buy-to-let (BTL) and HMO properties.

While HMOs often command higher gross yields compared to standard single-let BTLs, offering some inherent resilience, they are not exempt from the rules of Section 24 if they are held in a personal name.

Understanding the Mechanics of Section 24

Prior to April 2017, property investors could deduct 100% of their finance costs (primarily mortgage interest) and operating expenses from their rental income. They paid income tax only on the resulting net profit.

Section 24 changed this structure for residential lettings held by individuals, trusts, or partnerships. Landlords can no longer treat finance costs as a fully deductible expense. Instead, the government replaced the deduction with a fixed 20% tax credit.

The Calculation Shift: Deduction vs. Credit

To fully grasp how Section 24 impacts HMO mortgage profits, consider the two calculation methods:

• Old Method (Pre-S24): Rental Income – (Operating Costs + Mortgage Interest) = Taxable Profit.
• New Method (Post-S24): Rental Income – Operating Costs = Taxable Profit. Tax is calculated on this higher profit, and then a 20% tax credit (based on finance costs) is applied to reduce the final tax bill.

Crucially, the higher the interest payments a landlord incurs, the greater the disparity between the ‘old’ and ‘new’ systems. For highly leveraged properties, the taxable income can often appear greater than the actual cash profit, pushing the investor into a higher tax band.

The Direct Impact on HMO Profitability

HMOs, due to their multi-tenancy structure, typically involve more intensive management, higher utility bills, and potentially higher mortgage interest rates than standard BTLs (reflecting the specialised nature of HMO lending). Therefore, finance costs often represent a significant portion of the overhead.

Impact on Higher Rate Taxpayers (40% and 45%)

The impact is most acute for higher and additional rate taxpayers. Under the old system, a higher rate taxpayer received 40% relief on their interest costs. Under Section 24, they only receive a flat 20% credit. The remaining 20% or 25% of the finance costs effectively become an unavoidable tax burden, severely eroding net profit.

For example, if an HMO landlord pays £10,000 in mortgage interest in a year:

• Old System: £4,000 (40% of £10,000) was saved in tax.
• New System: Only £2,000 (20% credit) is returned, resulting in a net cost of £2,000 to the higher rate taxpayer.

This increased tax liability directly reduces the net cash flow generated by the HMO, potentially making marginal properties loss-making after tax, even if they appear profitable on a gross cash basis.

The Effect on Basic Rate Taxpayers

Even basic rate taxpayers (20%) are affected. While the 20% credit theoretically offsets the basic rate liability on the interest portion, the non-deductibility of finance costs increases the landlord’s total adjusted income. If this increase pushes their total income (including salary) over the higher rate threshold (currently £50,270 in 2024/2025), they suddenly become subject to the heavier impact of Section 24 described above, dramatically reducing HMO mortgage profits.

For official guidance on this restriction, you can refer to HMRC guidance on calculating property income tax.

Why HMOs Are Still Favourable (Despite Section 24)

While Section 24 impacts HMOs, the model often remains more robust than standard single-let BTLs due to superior yield generation.

The typical structure of an HMO provides a higher gross rental income per property unit. This higher income means that even with the increased tax burden, the remaining net profit may still outperform a less complex single-let property that is also subject to the same tax legislation.

Strategies to Mitigate Section 24’s Impact

Landlords seeking to maintain or improve their HMO mortgage profits have adopted several strategies to manage the impact of Section 24:

1. Incorporation (Using a Limited Company):

   The restriction only applies to individuals. Rental properties owned through a UK limited company are subject to Corporation Tax (CT), not Income Tax. Companies can still deduct 100% of their finance costs before calculating CT. While incorporating involves setup costs, administrative burdens, and implications regarding capital gains and dividend tax, it is the primary method used by professional landlords to offset Section 24.

2. Reducing Leverage:

   By paying down mortgage debt, landlords reduce their overall finance costs. Fewer finance costs mean a lower proportion of income is subject to the tax credit restriction, thus improving the net cash position.

3. Increasing Rental Yields:

   Focusing on high-value refurbishment (often financed via bridging or refurbishment mortgages) or improving management standards can justify rent increases, thereby increasing the gross profit margin available to absorb the higher tax liability.

4. Selling Highly Leveraged Assets:

   Some landlords choose to dispose of properties that generate very little positive cash flow after the Section 24 calculation, favouring properties with low loan-to-value (LTV) ratios.

It is crucial to seek independent advice from a qualified tax accountant or financial adviser before making substantial changes to your property holding structure, as the implications of incorporation are complex and long-lasting.

If you are exploring refinancing options or bridging loans to facilitate refurbishment or incorporation, remember that specialist finance often involves higher interest rates, which directly increases the financial costs restricted by Section 24. Your property may be at risk if repayments are not made. Possible consequences of default include legal action, repossession, increased interest rates, and additional charges.

People also asked

Does Section 24 apply to limited companies owning HMOs?

No. Section 24 only applies to residential property held by individuals, trusts, or partnerships. Properties held within a limited company are subject to Corporation Tax, allowing the company to continue deducting 100% of finance costs before tax calculation.

What counts as a ‘finance cost’ under Section 24?

Finance costs include all interest payments on mortgages, loans to buy furnishings, interest on overdrafts used for the letting business, and associated fees such as mortgage arrangement fees or broker fees related to securing finance.

Is there a difference between Section 24 and the wear and tear allowance?

Yes, they are separate tax matters. Section 24 relates to the restriction of finance costs. The ‘wear and tear’ allowance (a 10% deduction) was replaced in 2016 by a requirement to only claim tax relief on the actual costs incurred when replacing fixtures, furnishings, or equipment in the property.

Does Section 24 affect commercial property?

No, Section 24 applies strictly to residential lettings. Commercial properties, which include specialised commercial HMOs (e.g., certain care facilities or large institutions), are generally treated differently for tax purposes, allowing full deduction of finance costs.

Can Section 24 cause a landlord to report a loss for tax purposes?

No, Section 24 will never create a tax loss. The legislation prevents the tax credit applied to finance costs from exceeding the amount of tax due on the rental profits. However, it can often lead to a scenario where a landlord pays tax even though their cash flow is negative due to high mortgage costs.

Conclusion

The primary consequence of Section 24 for HMO investors is the unavoidable increase in taxable income, which puts significant pressure on net profit margins, especially for those in higher tax brackets or those operating highly leveraged portfolios. While HMOs typically provide robust gross returns that help counteract this tax burden, successful HMO investment in the post-S24 era requires careful financial planning, potentially involving complex strategic decisions such as portfolio incorporation or de-leveraging to maintain profitability.

Understanding how Section 24 impacts HMO mortgage profits is essential for accurately forecasting true returns and making informed decisions about future investments and financing structures.