Common Tax Mistakes Made By Landlords

Jennifer Adams highlights some potential problem areas in tax returns and tax planning by landlords.

HMRC are alert to mistakes in tax returns, and where they find them will look more closely at a taxpayer’s affairs. To help reduce mistakes, HMRC have launched a range of Toolkits to highlight common errors that have attracted HMRC’s attention. Although the use of Toolkits is entirely voluntary, interestingly the Property Rental Toolkit is the most downloaded of the Toolkits.  Errors in relation to property tax are obviously not solely confined to the completion of a tax return. In this article, we look at some of the more common mistakes that a landlord might make in relation to property tax.

In the taxman’s eyes, the renting out of a property is a ‘business’, and should the property owner have borrowed to finance the purchase, then the mortgage interest paid is an allowable deduction. Mistakes are sometimes made by treating the entire mortgage payment as an expense, rather than just the element of interest paid. The annual mortgage statements from the mortgage lender will show the split between interest and capital repayments, to enable only the interest element of the repayments to be claimed.

A common strategy amongst ‘buy to let’ landlords is to release equity from their main residence by remortgaging and using the capital to purchase, but the amount of interest paid might not necessarily be fully tax deductible. For example, should the mortgage be for more than the market value of the property on the day it was first let then the interest claim is restricted (for further details see PTI September 2013 ‘The Most Powerful Tax Relief of All?’).

HMRC frequently challenge claims for pre-letting expenses on the basis that they are non-allowable, which is not necessarily the case. Should an expense be incurred that would normally be allowed and has been incurred no more than seven years before letting commenced, then a claim can be made. If the expense is allowable, the cost is treated as having been incurred on the day the landlord started the rental business, and is added to other allowable letting expenses for the first tax year of letting. Broadly speaking, if the property was in a letable condition before expenditure commenced then it is a revenue expense; otherwise it is capital and only allowable in the capital gains tax calculation on sale (for further details, see PTI October 2013 ‘Ready, steady go! Relief for Pre-letting expenses’, and PTI November 2013 ‘Doing up a property before you let?’). 

Many landlords believe that so long as someone is declaring the letting profit on a tax return then that is all that is needed. However, the rent and expenses must be declared in the proportion of ownership and declared on the tax returns of each owner, such that should the property be held in joint names as joint tenants for example, then the declaration is according to the split of ownership.

Property ownership as ‘tenants in common’ generally allows property to be owned in any proportion agreed between the co-owners. The split of ownership determines the share of profit to declare. However, the position is different for married couples, who are deemed to own a property as tenants in common in equal shares, receiving income jointly, whatever the split of actual ownership. In some cases, it may be more tax-efficient if they elect (via form 17) to be taxed based on their actual ownership proportion of the property. If the form is not submitted and acknowledged by HMRC, the 50:50 split remains (for further details, see ‘We’re in this together (Part 3)’ PTI September 2013).

Under the ‘only or main residence’ capital gains tax (CGT) exemption, it is not just the house that is exempt but (within limits) the gardens or grounds attached as well. However, care must be taken as to the order of sale, because should the residence be sold before the land then CGT is chargeable as the land will no longer be ‘attached’ to the residence. 

3. Neglecting to make arrangements such that a claim for lettings relief is allowed 

A rented property qualifies for residential lettings exemption (‘lettings relief’) on sale if the property has been the owner’s main residence at any time during the period of ownership. This is a very valuable exemption, calculated as broadly the lower of £40,000, the amount of private residence relief or the chargeable gain by reason of the letting. The relief is per person; therefore a property owned jointly is allowed maximum relief of £80,000. The property needs to be the principal private residence (PPR) ‘at some time’ during the period of ownership; thus should the property not have been used as the PPR but purchased as a ‘buy to let’ then the landlord needs to use the property as the PPR at some time during ownership. From April 2014, the rules are changing so that only the last 18 months (previously 36 months) of a property’s ownership is exempt under the PPR rules. Should the landlord wish to sell the property, the plan should be that, in between tenants, the property is used as the landlord’s PPR for a period. The last 18 months will attract PPR, and as the property was let for a period then full lettings relief is also available.

If no election is made then on sale HMRC will make its own determination as to which property is the PPR. There are no set rules for their decision, so it is better to make an election rather than none at all. Having made an initial election there is no limit to the number of times that the address can be changed. It is therefore recommended that the election be made immediately on purchase of the second property – thus ensuring that the two year time limit is not missed (for further details, see ‘How to nominate and vary your main residence’ in PTI January 2014).

‘Flipping’ is a perfectly legitimate tax planning exercise. However, if used too many times or in quick succession, there is the danger that HMRC will initiate an investigation in an attempt to prove that either the PPR exemption is invalid and that the real reason for nominating the properties is avoidance of tax, or the owner is a ‘serial seller’ such that any profit on sale is to be taxed under income tax rather than CGT rules. HMRC and the Land Registry computer systems are linked, so that properties sold in short succession can be identified and tax return declaration details checked.

Everyone makes mistakes. But if time is taken to complete a tax return correctly or to consider the best tax planning option, then the tax saving can be large.