Meg Saksida explains the tax treatment of rental income received by the owner in the capacity of a trader.
Usually, we focus on an individual making rental property income and the taxation rules for reporting the income and deducting the expenses from that income in their capacity as an individual.
However, it could also be the case that the rental business is not run by an individual in their capacity as an individual taxpayer, but in their capacity as an owner of a trade (or profession).
Is the rental income then trading or property income?
'Accidental’ landlord?
A number of situations may arise where rental income might be received within a trade or profession. For example, a trader may simply go out and purchase a property and let it out. This is simple, as it is clearly property income and taxable as such.
However, there are some other situations where it isn’t so clear cut. The trader could find themselves an ‘accidental’ landlord.
For example, an import business trader might have purchased a warehouse bigger than that which is required for their business needs right now, but they intend to grow to fit it. They may then wish to temporarily rent out some of the surplus floor space. Another example is where an accounting partnership has let a floor of an office building but due to dwindling clients, finds they unexpectedly do not need some rooms, which they decide to let out. Yet another example is a property developer who ordinarily builds properties to sell on, and who finds that due to a dip in the economy they need to let unsold properties out for a short period of time.
The legal position
As long ago as 1930, case law made a distinct separation between trading income and property income. In Salisbury House Estate Ltd v Fry [1930] 15 TC 266, it was indicated that the categories (or the ‘schedules’ as they were formerly called) income needs to be reported in, are mutually exclusive and ‘…the specific income must be assessed under the specific schedule’.
Letting out a property on its own is almost never considered to be a trade. For this reason, property income is usually taxed as property income and trading income as trading income. However, there are a few exceptions.
Income on surplus space let out
If a trader has surplus space in their business, and decides to let it out, this rental income (for buildings only, not land) can be included under trading receipts.
However, there are only limited circumstances that this applies to. The let accommodation should be only temporarily surplus to their business requirements, and the rent received needs to be comparatively small. It also needs to be a part of the current business premises.
For example, if our import business trader (see above) bought two smaller warehouses rather than one big one, let one out and used one for his business, the let one would simply be treated as property income. However, by buying a larger unit and temporarily letting out a part of it while they await sufficient growth to require the whole unit, the let income from the rented out part can be treated as trading income.
Expenses on surplus space let out
If a choice is made to treat the income as trading income, none of the income (or expenses) will be treated as property income. All associated expenditure on the rental income from the let surplus accommodation can also be offset against all trading income.
(a) Surplus space not let out
Sometimes, due to dwindling sales or a flux in the economy, property once fully used by a trader or professional becomes surplus to the requirements of the trade. If this property is not let out and remains empty, the expenditure on the cost of the square meters will be an eligible and tax deductible expense.
However, this must be due to a subsequent change in circumstances. If the size of the property was taken on in good faith when the business was at such a level where all of the space was required, the undertaking of the expense will have been at that time ‘wholly and exclusively’ for the business and can therefore continue to be offset for the duration of the contract. Conversely, if the trader renews the lease for a further period for the same square meterage with the full knowledge that it is not required for the business, the rent on this excess space would not be deemed to be ‘wholly and exclusively’ for the business and the excess square meterage would not be able to be offset.
(b) Surplus space let out
If the spare space is let out (not in accordance with the conditions above, so maybe it is not temporary or the rents are not comparatively small), the trader is still able to offset the expenses from their trading profits as the space was originally ‘wholly and exclusively’ for the business (subject to the provisos above).
However, any rental income from the sub-letting will still now strictly need to go to property income. Having the income (no expenses) taxed as property income and the expenses (no income) deducted from trading income is not always ideal. If the trader wishes the income and the associated expenses to both be taxed under the same category, they can both be taxed as property income but not trading income.
Note that if a loss occurs from the sub-letting, it is possible to deduct only the expenses up to the level of income in the property income category, leaving a nil balance to tax, and the excess expenses can be deducted against trading income.
Properties converted from stock to fixed assets
Usually, a completed property on the books of a property developer awaiting sale will have any expenses associated with it (e.g., heat, light, insurance etc.) deducted from trading profits. However, if time ticks on before a buyer is sold, there may be a decision made to let the property out while waiting for the property to be sold. In these cases, the expenses on the property are no longer trading expenses but property income expenses and the income is taxed as property income.
However, as explained above with surplus space, if the completed property were not to be let out because the expenses would have fallen to be treated as from trading, just as before in the case of an excess expenses over rental income prior to the sale, it is possible to deduct only the expenses up to the level of income in the property income category, leaving a nil balance to tax, and the excess expenses can be deducted against trading income.
Practical tip
Most of the time, lettings made by a trade or a profession will need to declare income and associated expenses to property income. However, in many cases using trading income may be preferable due to the more generous ability to offset losses, capital gains reliefs, and that the income can be considered as earnings for pension purposes. But beware; the circumstances where property income can be classified as trading are few and the conditions are strict.
