The paradox of Section24

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Last week a reader pointed out that the gross yield figures that are bandied about are misleading and we should concentrate on the return on investment (ROI).

https://www.property118.com/using-net-rental-yields/

The gross yield is the annual gross rent as a percentage of the value of the property.  The ROI is the after-tax profit as a percentage of the amount invested, basically the deposit where a mortgage is involved.

He did a calculation based on the following average figures: property price £190,000, rent  £850 per month, loan 60%, interest rate of 4.5%,running costs which included full management or an employed team for the larger landlord like himself which costs 30% of the rent. He arrived at an ROI of 2.01%.  The gross yield is 5.4%

The consensus was that ROI is much more useful.  And somebody pointed out that we now have to take S 24 into account as it dramatically reduces after-tax profit where finance costs are incurred.

He asked readers to check his calculation.  Using the above figures per unit I tried to calculate how many units he had in order to arrive at an ROI of 2.01%.  Assuming that there were no joint owners, and he had no other income, the answer is nearer 40 than 20.

This calculation revealed a paradox.  Normally you would expect a bigger portfolio to produce a bigger after-tax income in absolute terms, and this is what happened until last year.  As the table shows, after tax income does not exactly double as the number of units doubles, but it grows from £34k to 60k to £103k

However, under S 24, after-tax income will go down in absolute terms as the size of the portfolio doubles, from £10k to £7k to almost nothing – 50p per property per year.

At 81 units the tax will exceed 100% of the real profit.

And at each size, the fictitious profit will rule out entitlement to any benefits.

The owner’s work will just be for the benefit of his tenants, his employees, his lenders and his government.

I then calculated what effect S 24 would have on ROI as from 2020/21 when it is fully phased in.  At 20 units it will be reduced by seven-tenths.  At 40 units it will be reduced by nine-tenths.  At 80 units it will be extinguished.

The effect of Section 24 of the Finance (No.2) Act 2015 on different sizes of portfolio

The real profit figures are on the line “Amount liable to tax” in the columns headed 2016/17

The extra tax is about 45% on the interest, minus the 20% “relief”.

To avoid bankruptcy he needs to increase the rent.  He should have started to do so before April when S24 began to be phased in. To maintain the same after-tax income as he had last year he will need to increase the rent by the above percentages before April 2020, from £850 to about £1,050.

It is not sufficient to increase rents by the amount of extra tax because the increase itself will be taxed at 45%.

I have assumed that his 30% management costs do not include any agents fees that would go up in line with rents.  If there are, he will have to increase rents even more

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