Buy-to-Let Investment: How Profits Are Calculated

Rezumat

Buy-to-Let (BTL) is a property investment strategy where you purchase a residential property to rent out. The goal is to generate rental income that exceeds mortgage costs and operating expenses, creating positive cash flow. However, since 2020, Section 24 tax rules have fundamentally changed BTL profitability — especially for higher-rate taxpayers, who can no longer deduct mortgage interest from rental profits before calculating tax. Instead, they pay tax on the full rental profit, then receive a 20% tax credit on mortgage interest.

This often means a property showing profit before tax becomes a loss-making investment after tax.

Cum funcționează

Buy-to-Let profitability depends on five components:

1. Rental income — monthly rent × 12, minus void periods (weeks when the property is empty)
2. Operating costs — management fees, insurance, maintenance, ground rent, service charge
3. Mortgage costs — interest-only or repayment mortgage payment
4. Section 24 tax — income tax on rental profit, minus 20% credit on mortgage interest
5. Upfront investment — deposit plus stamp duty (with 5% BTL surcharge)

Section 24: The game-changer

Before April 2020, landlords could deduct mortgage interest from rental income before calculating tax. A higher-rate taxpayer with £10,000 rental profit and £8,000 mortgage interest would be taxed on just £2,000.

Since April 2020 (Finance Act 2015, fully phased in):

• Mortgage interest is not deductible from rental profit
• Instead, you get a 20% tax credit on mortgage interest (regardless of your tax band)
• You pay income tax on the full rental profit at your marginal rate (20%/40%/45%)
• Net tax = income tax - 20% credit

Why this matters:

• Basic-rate taxpayers (20%): Section 24 has no impact — 20% tax offset by 20% credit
• Higher-rate taxpayers (40%): Effective tax rate on true profit can exceed 100%, turning profit into loss
• Additional-rate taxpayers (45%): Even worse impact

From April 2027, the tax credit increases to 22% when the basic rate of income tax changes.

Lender stress test

Mortgage lenders require that monthly rent covers at least 125% of the mortgage interest at a stressed rate of 5.5% (regardless of your actual rate). Higher-rate taxpayers may face a 145% coverage requirement with some lenders.

Stress test formula:

Coverage ratio = Monthly rent / (Loan amount × 5.5% / 12)

If this ratio is below 1.25 (125%), lenders will reject your application — even if the property is profitable at your actual mortgage rate.

The formulas

1. Interest-only mortgage payment

Most BTL mortgages are interest-only because landlords prioritize cash flow over building equity.

2. Repayment mortgage payment

3. Section 24 tax calculation

The net tax is floored at £0 — you can’t get a refund if the credit exceeds the income tax.

4. Cash-on-cash return

This is the true ROI metric for BTL — what return are you getting on the cash you’ve locked up?

5. Rental yields

Gross yield (headline figure in property listings):

Gross yield = (Annual rent / Property price) × 100

Net yield (accounts for operating costs):

Net yield = (Annual rent - Operating costs / Property price) × 100

Net yield is more useful because it reflects actual cash flow before mortgage and tax.

Exemplu rezolvat

Scenario: Higher-rate taxpayer (40%) buying a £250,000 BTL property

Inputs:

• Property price: £250,000
• Deposit: 25% = £62,500
• Loan: £187,500
• Mortgage: 5.5% interest-only
• Monthly rent: £1,200 (£14,400/year)
• Void weeks: 2 weeks/year
• Management fee: 10%
• Insurance: £500/year
• Maintenance: £1,000/year
• Ground rent: £0
• Service charge: £0

So far, the property looks profitable. But now Section 24 tax applies.

The Section 24 aha moment: This property shows a £49/month profit before tax, but becomes a £142/month loss after tax. The effective tax rate on the true profit (£593.65) is 387% — you pay £2,300 in tax on £593 of profit.

Upfront costs

Total upfront investment: £62,500 (deposit) + £15,000 (stamp duty) = £77,500

Stress test

Lender stress test at 5.5%:

Interest-only payment at 5.5% = £187,500 × 5.5% / 12 = £859.38/month
Coverage ratio = £1,200 / £859.38 = 1.396 = 139.6%

Result: PASS (≥125% required)

The property passes the lender stress test, but still loses money after tax.

Intrări explicate

• Property price — agreed purchase price
• Deposit % — BTL mortgages typically require 25% minimum (some lenders accept 15-20%)
• Mortgage rate — annual interest rate (BTL rates are ~1-2% higher than residential)
• Mortgage term — typically 25 years (interest-only terms may be capped at 15-20 years)
• Payment type — interest-only (most common) or repayment
• Monthly rent — what you can realistically charge (check Rightmove, Zoopla comparables)
• Management fee % — typically 8-12% of annual rent if using a letting agent
• Annual insurance — landlord insurance (buildings + contents + liability) — typically £300-600
• Annual maintenance — budget 1-2% of property value or £1,000-2,000/year minimum
• Void weeks — weeks per year the property sits empty between tenants (1-4 weeks typical)
• Ground rent — annual charge for leasehold properties
• Service charge — for flats/apartments with communal areas
• Tax band — your marginal income tax rate based on total income (20%/40%/45%)

Rezultate explicate

• Monthly profit before tax — real cash flow: rent minus all costs and mortgage payment
• Monthly profit after tax — what you actually pocket after Section 24 tax
• Stamp duty — includes 5% BTL surcharge on every band (from 31 Oct 2024, previously 3%)
• Total upfront cost — deposit + stamp duty (what you need to invest today)
• Gross yield — annual rent / property price (industry standard, ignores costs)
• Net yield — (annual rent - operating costs) / property price (more realistic)
• Section 24 tax breakdown — shows exactly how the tax is calculated
• Cash-on-cash return — annual profit after tax / total upfront cost (true ROI)
• Rental coverage ratio — monthly rent / actual mortgage interest payment
• Stress test coverage — monthly rent / interest payment at 5.5% (must be ≥125%)

Ipoteze și limitări

• England/Northern Ireland only — Scotland and Wales have different LBTT/LTT rates and bands
• Residential BTL only — commercial, HMO (Houses in Multiple Occupation), and holiday lets have different tax treatment
• Income tax only — does not model Capital Gains Tax on property sale or Inheritance Tax
• Marginal rate assumption — assumes rental profit is taxed at your top marginal rate (true if you have other income)
• First-year costs only — maintenance and mortgage interest vary over the property lifetime
• No portfolio cross-relief — if you have multiple BTL properties, losses on one can offset profits on another
• Repayment mortgage interest — calculator uses Year 1 interest for Section 24 credit. Interest portion decreases over time, so tax credit also decreases.
• Void weeks — assumes even distribution. In reality, voids are lumpy (e.g., one 4-week gap, not 2 weeks every 6 months)
• Selective licensing — some councils require landlord licenses with additional fees (not modeled)
• Limited company structure — BTL properties owned via a limited company have different tax treatment (corporation tax at 25%, no Section 24 impact). This calculator assumes personal ownership only.

Verificare

All test cases verified against manual calculation and cross-checked with worked examples from gov.uk guidance.

Accounting identity test

The following identity must always hold:

Annual profit after tax = Effective rent - Operating costs - Mortgage payment - Net tax

For the worked example:

£13,846.15 - £2,940 - £10,312.50 - £2,299.96 = -£1,706.31 ✓

Cash-on-cash return verification

For a higher-rate taxpayer:

Annual loss after tax: -£1,706.31
Total upfront: £77,500
Cash-on-cash return: (-£1,706.31 / £77,500) × 100 = -2.2%

This is a negative return — you’re losing 2.2% per year on your invested capital.