The Hornbeam Guide to Taxation of Residential Letting
Contents
1 Computation of Profit
1.1 Capital Expenditure and Maintenance
1.2 Expenditure Before Letting Commences
1.3 Interest Expense
1.4 Other Expenditure
1.5 Issues Concerning the Recording of Rental Income
2.1 Income Tax
2.3 VAT
2.5 Inheritance Tax
3.2 Serviced Letting
3.3 Holiday Lets
4 Whether to Incorporate
4.1 Profit Taxes
4.2 Stamp Duty Land Tax
4.3 Regulations and Costs
4.4 Capital Taxes
4.5 The Rare Case
4.6 Summary
4.1 Profit Taxes
4.2 Stamp Duty Land Tax
4.3 Regulations and Costs
4.4 Capital Taxes
4.5 The Rare Case
4.6 Summary
Introduction
This guide is written primarily for individuals who own and let residential property.
Our objective is to write in plain English, about an area of tax that is both complex, and rapidly changing. Only you will judge whether we have been successful.
Chapter 1
Computation of Profit
1.1 Capital Expenditure and Maintenance
It is when you first buy your property that you are most likely to spend a lot of money doing it up. There is therefore a big issue as to what expenditure is allowable against your (future) rental income and what is not allowable for tax purposes. This has changed quite a bit over recent years and we set out here our understanding of the current position.
In general there are no allowances (no depreciation, no capital allowances) against rental income for capital expenditure on the purchase or improvement of a property for residential letting.
Capital expenditure will be allowable in the Capital Gains Tax computation when you come to sell the property, Our advice is to keep a careful and accurate record of your capital expenditure, it will be important in reducing your tax at some time in the future. Ideally you should record these capital costs in the balance sheet of the full accounts which are maintained for your rental business. |
On the other hand there is full allowance for expenditure on maintenance of a property. It is therefore critical to distinguish between maintenance and capital expenditure.
– The purchase of the land, the buildings on it, together with legal fees and stamp duty land tax will be capital expenditure.
– Any addition to the premises is capital expenditure. Quoting from HMRC Property Income Manual “if you add to the premises something that was not there before, for example if you build an extension or a new porch, this is capital expenditure. It does not matter how small the addition is. If you add an extractor fan or fit an additional cabinet in the bathroom or kitchen, this is also capital expenditure”.
– the cost of refurbishing or repairing a property bought in a derelict or run-down state is capital expenditure.
HMRC are very interested in this last point; their manual states that where a property is bought which is not in a fit state for use, or where the price paid for the property was substantially reduced because of its dilapidated state, this may mean the expenditure was capital.
Furthermore HMRC go on to tell us that where standard kitchen units are replaced by expensive customised items using high quality materials, the whole of the expenditure will be capital. There is no longer any deduction for the replacement element of the upgrade, the whole cost is disallowed.
We think that these two rules combine to make those first few weeks after you buy a property a very dangerous time. To avoid finding large elements of your costs disallowed against your rental income, we recommend that if at all possible
– Let the property before undertaking the maintenance.
– Carefully distinguish between maintenance works and improvements, get separate quotes, and do not carry out improvements at the same time as regular maintenance.
The HMRC manual identifies the following as (tax allowable) maintenance expenditure
– exterior and interior painting and decorating,
– stone cleaning,
– damp and rot treatment,
– mending broken windows, doors, furniture and machines such as cookers or lifts,
– re-pointing, and
– replacing roof slates, flashing and gutters.
Furthermore HMRC accept that replacing an old window with a modern double glazed window is not an improvement, but just the modern equivalent, hence it is a replacement not an improvement and is thus allowable in the computation of profits.
Furthermore the courts have pretty much accepted that for residential lettings the whole entity is the house or block of flats, if you replace the leaking roof with a new one this will be a repair (but if you substantially rebuild the whole entity that will be capital).
There are no capital allowances for buying the furniture and fittings that first go into a rented property. However just as one can claim for replacement windows so one can claim for replacement furnishings
Your solicitor will obtain a full list of furnishings and fittings included with the property. You should ask the solicitor to ensure that a small part of the price is allocated to these items (the solicitor will be familiar with this as a process for minimising stamp duty land tax). You can then at least demonstrate that your first burst of expenditure is on replacement of fittings, not new items.
There is an alternative allowance of 10% of net revenue against the wear and tear of furnishings of fully furnished residential lettings (see 3.1).
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1.2 Expenditure Before Letting Commences
The business of letting does not start until the first property is let and therefore pre -commencement expenditure cannot be claimed until letting commences. This is in accordance with normal accounting practice. Of course when letting does commence pre commencement expenditure can be claimed in the first period.
This rule is applied on a business by business basis, not a property by property basis, so an existing rentals business can claim for expenditure on a property which has not yet been let in the period in which the expenditure is incurred.
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1.3 Interest on Borrowings
Prior to 2005, only interest incurred on loans taken out to purchase or improve a let property was allowable. The Revenue still seem to think this is the case, that on first principles only interest on loans taken out wholly and necessarily for business purposes will be allowable.
However, the consensus amongst tax professionals is that most interest on borrowing will be allowable, provided that, broadly speaking; the amount borrowed is less than the purchase price of the property. For example the view of Lakshmi Narain in the CCH guide to ‘Tax on Property’ is that “The purchaser of a property may finance the purchase using his own funds, by borrowing or by a combination of both. If the purchase is financed wholly or partly by the purchaser’s own funds, the purchaser may, at some future date, decide to withdraw part of his own capital from the property business and replace it with borrowings. In this case interest on the additional borrowing is not automatically excluded from relief…..the amount of capital withdrawn should not exceed the amount of capital introduced. Further if the amount of gearing is so high that the letting is unlikely to show a profit HMRC may seek a disallowance of interest under the ‘wholly and exclusively’ rule.”
Many buy-to-let landlords are living upon remortgage monies, and presumably claiming the interest on the loans. We are not aware of the outcomes of the inevitable disputes between HMRC and landlords.
There are various strategies that we would advise to avoid conflict with HMRC
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1.4 Other Expenditure
Most other expenses of running a letting business should now be allowed without too much trouble. Here are a few tips
Travel
– We recommend that our landlords keep a travel diary and claim for business mileage (currently at 40p per mile for the first 10,000 miles.), which is not particularly open to dispute by HMRC inspectors. However it remains an option to claim for all motor expenses then disallow the private proportion, but you still should keep mileage records.
Protective Clothing
– You can always claim for health and safety gear (steel toecap boots, overalls, safety helmet, but if you prefer to do your maintenance wearing trainers, jeans and baseball cap don’t expect any cost to be allowed.
Laundry
– Don’t forget to claim for laundry costs whilst doing maintenance.
Use of home as office
– Don’t forget to claim for use of home as office if you have a home office.
Telephone
– Use some reasonable method to identify business phone costs – the best technique for all sorts of reasons is to have a separate phone (and answer-phone) for the business (if the costs are enough to justify the expense).
Since 2005 all but the smallest rental businesses must prepare full accounts, matching costs with revenues over time (the accruals basis) and in accordance with Generally Accepted Accounting Principles.
Like all businesses, landlords have to maintain proper records, and to keep these for at least six years.
So far we have never come across an Inspector levying any part of the maximum £3,000 fine for failure to maintain records. However, we are concerned that at some point HMRC policy will change; therefore we always recommend our clients keep full records.
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1.5 Issues Concerning the Recording of Rental Income
- Broadly speaking the total gross income due to the landlord in the period will be the figure the Revenue is looking for in the income box.
- Gross income means before agent’s commissions (but agent’s commissions are an allowable expense).
- Due to the Landlord means rents still unpaid at the year end must be accounted for as income, consideration must then be given as to whether a bad debt provision needs to be made.
- It is very important that you, as landlord, document any void periods – keep records of when the old tenancy ceased and the new tenancy commenced – the Revenue inspector will want to know (It is the inspectors job to look for understated income!)
- For individuals or couples who are landlords the period will always be 6 April to 5 April.
- Deposits are not income until it becomes clear that they will be held against a specific item of expenditure.
- Lease premiums can also be income for tax purposes. See below
Actually there are not usually any major issues in recognising income from residential lettings.
Lease Premiums
Although lease premiums are rare for residential landlords, it is perhaps worth knowing how these are taxed
a) A lease is a legal right to occupy a property for a specified time for a specified rent.
b) A premium is the amount paid by a tenant to a landlord for the granting of the lease.
c) If the lease is for more than 50 years there is no income tax charge, but the premium will be liable to Capital Gains Tax.
d) If the lease is for less than 50 years (a short lease) then the premium paid is subject to income tax.
e) This is calculated as follows
Premium P
Less: 2%xPx(n-1) (C)
Income A
Where n is the number of years of the short lease.
f) Income (A) is charged to income tax in the year of receipt.
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Chapter 2
Taxation of Residential Letting
2.1 Income Tax
The profits from a landlords rental business are added to their other income and taxed at the appropriate rates.
Usually HMRC expect rental profits from jointly owned properties to be split between the owners in the same proportion as the properties are owned. For husband and wife it is always assumed to be a 50:50 split unless it is owned in different proportions and they elect to have it split according to that ratio.
Rental profit is not ‘Relevant Earnings’ for pension purposes, so landlords can’t get income tax relief for making payments into a pension fund.
Losses from residential letting can never be set off against other income in the same or future tax years and can never be carried back (contrast with Furnished Holiday Lets 3.3).
Losses from residential letting are first set off against profits of any other property letting business in the same year. If there are losses from property letting overall these are carried forward against future profits from letting. They are set off against the first future profits automatically.
Where property is let for less than a commercial rent (e.g. to a friend or family member) this is known as a ‘Nominal’ lease. In this case expenses are only allowable up to the amount of the rent received, and therefore a loss can never be created!
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2.2 National Insurance
Because they are not considered to be earned income, profits from a letting business are not subject to National Insurance.
This simple fact gives landlords a considerable tax advantage over other traders, a fact which is often forgotten when established letting businesses campaign to be taxed as any other trade (to get capital gains tax advantages). However this advantage does not apply to
– Property letting businesses making a loss
– Landlords who already pay the maximum NI (the saving is still 1% here)
– Incorporated property businesses
Not paying National Insurance also makes tax planning for Landlords completely different to tax planning for other traders.
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2.3 VAT
Residential Lettings are exempt from VAT (although there is an option to charge VAT). Except in the case of serviced lettings, where the customer is a corporate body rather than individuals, it is unlikely to be worth a residential landlord considering VAT.
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2.4 Capital Gains Tax
Whereas Residential Landlords are pretty much exempt from worries about National Insurance and VAT, Capital Taxes are a major worry. Many buy-to-let landlords in particular seem to be in the business for Capital Appreciation (and in a country where planning laws create a permanent shortage of residential accommodation this has paid off handsomely for many).
Capital Gains Tax is levied upon the difference between the net sales proceeds and the costs of buying and improving a property.
So the first point is to make sure you have all the allowable costs mustered: – Legal fees of buying and selling – Agents fees of selling – Any Stamp Duty Land Tax paid – All those improvements that were not allowed as costs against the rental income. – Purchase cost. Keeping these records over many years requires iron discipline, but is well worth the effort. |
From April 2008 for individuals who are residential landlords, decades of complicated rules concerning indexation (until 1998) and taper relief (until 2008) have been swept away. Instead property gains will be taxed at a flat rate of 18%.
For most residential landlords this is a big improvement on the situation prior to 2008. Gains on properties sold in the first two years could easily be taxed at 40%. At the other end of the scale properties owned 10 years attracted 40% taper relief and thus were taxed on higher rate taxpayers at 24%. Of course basic rate taxpayers paid only 20% or even 12% tax on their gains.
There are two other reliefs crucial to Capital Gains Tax planning:
Firstly, each property owner has an annual exemption (£9,600 for 2008/9.) in addition to the annual allowance for income tax purposes.
Where appropriate, the strategy for tax minimisation should therefore include making sure that a husband and wife each own 50% of a property before sale. If this is not so, your solicitor can prepare a “deed of variation”, which does not attract stamp duty or Capital Gains Tax! Both partners can thus benefit from the annual exemption. A strategy for tax minimisation should aim to spread the sale of properties (making capital gains) over the years, to maximise the number of annual exemptions and lower rates of tax that are utilised. However, it is not usually practical to realise property gains just to minimise Capital Gains Tax. Stamp-duty-land-tax, solicitor’s fees, and agent’s fees will tend to outweigh any Capital Gains Tax saving. |
Secondly, there is the much loved Principle Private Residence Relief. British people “know” that they do not pay capital gains tax when they sell their own home.
- To obtain Principle Private Residence Relief the owner must live in a house as his own home at some point.
- An individual or a married couple can only have one Principal Private Residence at a time.
- If a person lives in a property for only part of the time he owns it then the Principal Private Residence Relief is given pro-rata to the period of occupation – but the last three years of ownership are always treated as a period of occupation for calculation of Principal Private Residence Relief.
Example 2.4.1 Jim sells a house making a £100,000 gain; he has owned the house for 100 months. He occupied the house for 3 months when he first bought it, after which he moved out and allowed his mother to occupy the property free of charge. Jim gets 3 months Principal Private Residence Relief for the first 3 months of actual occupation, plus the last 36 months of ownership, 39 months in total. His total Principal Private Residence Relief is £39,000 being the £100,000 gain multiplied by 39 months/100 months. |
- There is a further less well known relief, called Letting Relief. If after occupying a property himself the owner lets the property, he is entitled to a further relief (effectively an extension to Principal Private Residence Relief) related to the period of letting but limited to a maximum of the lower of the amount of the Principal Private Residence Relief or £40,000 or the gain made in the period of letting.
Example 2.4.2 So if Jim had let the property instead of allowing his mother to occupy it free of charge he would have been entitled to £39,000 Principal Private Residence Relief, plus a further £39,000 letting relief – a total of £78,000 of the gain would be free of Capital Gains Tax. |
Example 2.4.3 If Jim had occupied the property for 5 months instead of 3 he would be entitled to £41,000 of Principal Private Residence Relief, but his letting relief would be restricted to £40,000 |
These are valuable tax reliefs to Landlords who do not mind living in a property themselves for a short period of their ownership.
A Landlord may already have a £500,000 residence and would have some trouble in convincing the tax inspector that the £100,000 residence he is occupying during the week (whilst he renovates a nearby property) is his main residence. Fortunately he doesn’t have to. A taxpayer (or married couple) may, within two years of a change in the number of residences which they occupy, nominate which property is to be their Principal Private Residence.
Example 2.4.4 Jim has lived in a £500,000 house in mid Norfolk and hopes to be there for many years to come. Whilst his daughter is at University in Manchester, Jim becomes interested in the buy-to-let opportunities in that City. He buys a terraced house close to the University and spends the next ten weeks renovating the property. As he finishes the property he buys a further property on the next road and begins to renovate that, still staying in the first property during the week. Jim’s accountant finds out what he has been up to at the next meeting and as it is within 2 years of the purchase of the first Manchester property nominates that as Jim’s Principal Private Residence from when it was purchased. A couple of weeks later he changes the nomination back to Jim’s Norfolk property, with effect from a couple of months after purchase of the Manchester property. As we have seen in example 2.4.2 this nomination of the Manchester property for a couple of months might easily wipe out the Capital Gains Tax charge on the first Manchester property when it is eventually sold. |
HMRC are likely to look at such nominations pretty hard, so make sure
- You can prove that you actually lived in the house, by keeping utility and telephone bills and ordering milk and newspaper, for example.
- The nomination is technically correct in all its particulars.
- Don’t overdo it – if you change nomination repeatedly HMRC will try much harder to prove that you did not actually occupy these properties as your home (actually the onus will be on you to prove that you did).
To conclude, by organising ones affairs appropriately it is possible to massively reduce Capital Gains Tax. However, we have observed over the years that the majority of landlords are pretty reluctant to move home “just” to minimise tax!
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2.5 Inheritance Tax
Inheritance tax is charged on estates over £312,000 at 40% of the excess over £312,000 (in 2008/9)
For the children (beneficiaries) of more successful Residential Landlords this can be a massive tax.
Example 2.5 Jim dies leaving an estate worth £2,312,000. His executors will have to find £800,000 Inheritance tax within 6 months of the end of the month in which death occurs. |
Inheritance tax requires a whole leaflet on its own account (please ask us for a copy),
The main ways to minimise this tax are
- Spend it before you die – many people’s preferred option!
- Make sure you have appropriate wills (so that each spouse uses their £312,000 allowance effectively)
- Consider lifetime gifts – there are complex rules covering gifts both large and small.
- Gifts out of income are allowed as long as the donor’s lifestyle is not harmed, so instead of growing your investments consider setting up standing orders in favour of the grandchildren – or whoever.
- Consider insurance products.
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Chapter 3
Special types of letting
3.1 Furnished Lettings
The rules for furnished lettings are broadly the same as for other types of letting. However for furnished lettings only, the landlord can opt to forgo claiming for replacement furnishings and to claim a 10% reduction in the rent instead.
We rather like this option. Most properties are let with carpets, curtains, kitchen fittings and equipment, but they are not furnished unless there is also provision of a bed, wardrobe, sofa, table and chairs (i.e. it is possible to live in the property). Most landlords could source these items for relatively small cost and thus obtain a 10% reduction in their taxable income…. Some of our more thoughtful clients have expressed the view that the furnished lettings industry is much more trouble than unfurnished letting, which is a good point but… More income can be earned from furnished lets than from unfurnished lets. Anyway, you must decide what market you are targeting, and if you decide to provide furnished lettings, you can consider taking advantage of the 10% allowance. |
Furnished lettings are still considered to be rental income for all other Income Tax (i.e. not relevant earnings for pension purposes), National Insurance, Capital Gains Tax, and IHT purposes.
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3.2 Serviced Lettings
Some landlords provide serviced lettings. Serviced properties are usually let to visiting business people. The services may include laundry and maid services.
Serviced lettings are still rentals for income tax purposes, although the landlord has the option of splitting out the services business and having that taxed as a trade.
Serviced lettings are inevitably furnished lettings and so the landlord has the option of claiming the 10% income reduction.
As rentals for serviced lettings are pretty high a 10% reduction will tend to be quite valuable…. |
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3.3 Furnished Holiday Lets
To qualify as a holiday let a property must be
- Furnished
- Situated in the UK – e.g. a French farmhouse is never a Furnished Holiday Let for tax purposes.
- Available for commercial letting to the general public for at least 140 days in the relevant period (usually 12 months),
- Actually let for at least 70 days,
- Not in the same continuous occupation for more than 31 days per visit.
Being defined as a Furnished Holiday Let has the following advantages.
- Profits are treated as EARNED income and therefore are relevant earnings for pension contribution purposes
- Capital Allowances are available (although wear and tear allowance is not).
- Losses can be set off against other income (such as salary, dividends or interest) in the year.
- Furnished Holiday Let’s qualify for various Capital Gains Tax Reliefs such as Rollover Relief and Gift Relief.
However, it is proposed that the tax advantages for Furnished Holiday Lets will be withdrawn from 6 April 2010.
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3.4 Non UK Property Business
If a taxpayer lets out an overseas property such as an apartment in Florence or villa in Bulgaria, the profits are charged to Income Tax as ‘Foreign Income’.
The profits are calculated in the same way as for a UK property.
If there is a loss, this can first be set against other foreign income of the same year. If not fully utilised, then the remainder of the loss can only be carried forward against future non UK rental business profits. FOREIGN PROPERTY LOSSES CAN NEVER BE SET AGAINST UK PROPERTY PROFITS (and vice versa) unless the UK property is a Furnished Holiday Let.
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3.5 Bed and Breakfast Accommodation
Letting Bed and Breakfast accommodation is a trade for tax purposes – not property income – and as such:
– Capital Allowances can be claimed on furnishings
– Losses are treated differently
– Profits are relevant earnings for pension purposes.
– National Insurance is payable on profits.
– Capital Gains Tax rules are different
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3.6 Rent-a-Room Relief
If you let out a room or rooms in your own home and you also live in the house yourself, you have a choice of how this can be treated. Either the normal rules of income and expenditure apply (including the possibility of it being treated as the carrying on of a trade, if you are providing services for the tenants), or alternatively you can simply deduct the “rent a room relief” of £4,250 from the rent. There is one allowance per property, not per room rented!
This allowance is particularly valuable to any taxpayer who takes a lodger into their home. |
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Chapter 4
Whether to Incorporate
We are often asked whether it is worth incorporating a residential letting business.
The answer is that the pro’s and cons of incorporation are extremely complicated, and like so many things relating to tax it depends on your existing situation and on how you view the future…. Here are some of the main factors.
4.1 Profit Taxes
Many small businesses have been incorporated so that that income ends in the hands of the proprietor as dividends rather than trading profit, and thus National Insurance is avoided. Although changes in the April 2007 Budget eroded the advantage of incorporation, this basic principle remains effective for small traders. However, Landlords don’t have to pay National Insurance, so the fact is that small incorporated letting businesses will now pay more tax on profit than equivalent unincorporated businesses. This will be decisive in persuading most small letting businesses not to consider incorporation further.
For larger businesses with rental profits over £50,000 there may still be a reduction in income taxes from incorporating, but this will depend on a number of factors, particularly how much of the profit is to be withdrawn and how much retained for reinvestment.
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4.2 Stamp Duty Land Tax
Another factor which will make incorporation of an established letting business impractical is stamp duty land tax. This tax, plus legal fees, will tend to make the cost of conveying an existing property portfolio from individual ownership to company ownership prohibitively expensive.
On the other hand an entrepreneur starting to build up a property portfolio might prefer to do this in a company, in that if the entrepreneur sells the company, rather than the properties, Stamp Duty will be at half a percent on the shares compared with a maximum of 4% on the properties.
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4.3 Regulations and Costs
Legislation regulating the operation of Limited Companies and the conduct of directors is extensive and restrictive. Although there are some advantages (Limited Liability for shareholder-investors is the obvious example) these regulations are inevitably seen as red tape by most landlords. These rules lead too much more complex sets of accounts which have to be deposited at Companies House. Thus accountant’s costs are inevitably higher than for an equivalent sole trader.
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4.4 Capital Taxes
The Capital Gains Tax regime is different for companies. There is no taper relief, but companies still receive an indexation allowance based on the cost of the property and general inflation as per the indexation. If you think that property costs are now rather high and that property inflation is unlikely to exceed general inflation in the coming years then this might be a considerable advantage.
However, the problem with companies is getting the profit out. Higher rate taxpayers will pay £25 income tax on every £100 of net dividend received. Capital distributions will also be highly taxed (remember this is not a trading business so the maximum 40% taper relief applies not the 75% which investment in a trading business would attract).
Finally, there is no Inheritance Tax advantage or disadvantage with incorporating. The shares will pass into the estate, presumably at the same value as the properties, and will attract the same 40% tax as would have the properties themselves.
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4.5 The Rare Case
Some years ago, some tax whiz came up with the following idea. Husband is a higher rate taxpayer, wife is not. Company is 90% owned by wife, 10% by Husband. Husband borrows £200,000 which he lends to Company free of interest. Company buys residential property and lets it out. Husband gets 40% tax relief on the interest on his £200,000 borrowing. Company pays 20% tax on the letting profit, which it distributes 90% to wife who has no further tax to pay.
So the husband gets 40% tax relief on the loan, but the company pays only 20% tax on the rental income – HMRC help to fund the letting business!
We have to admit that whilst we have known about this possibility for several years, we have yet to set one up!
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4.6 Summary
It will be very rare that it is worth setting up a company to handle new residential lettings.
It will be incredibly rare that it will be worth changing the incorporation status of existing residential lettings.
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Chapter 5
Disclaimer
Taxation is incredibly complex, and incredibly easy to get wrong. This leaflet is intended as a guide to some of the main factors influencing the taxation of Residential Letting. Almost every rule set out in this guide will be subject to many exceptions and caveats. You should not take action based on what is written in this guide. If you think something applies to you, you should obtain specific qualified advice concerning your particular situation.
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