*At the time of publication, the Autumn 2019 Budget has been postponed and a new date has not been announced*
Sarah Bradford explores the income tax and capital gains tax implications of letting out a room in an owner’s own home.
The rent-a-room scheme was introduced in a bid to increase the supply of cheaper private rented accommodation by providing income tax breaks for those who let out a furnished room in their own home.
However, taxes do not work in isolation and while letting out a room may enable the owner to enjoy some tax-free income, it may also have fewer welcome implications from a capital gains tax (CGT) perspective.
Income tax implications
The rent-a-room scheme enables resident landlords to earn income tax-free from letting furnished accommodation in their own home. It does not matter how much of the home is let out as long as the conditions are met. However, it only applies to let accommodation in the landlord’s own home, not to a separate rental property.
The rent-a-room scheme enables the resident landlord to earn up to £7,500 per year tax-free from letting furnished accommodation in his or her own home. The home does not have to be owned – the scheme applies equally to furnished accommodation let in a home that is rented (however, it is prudent to check before renting out a room in a rented property that this is allowed under the tenancy agreement). The scheme can also be used by those running a bed and breakfast or guest house where the landlord lives.
Where more than one person receives income from the letting of the furnished accommodation, the tax-free limit is £3,750 per person – this applies even if more than two people receive rental income, so that the total that may be received tax-free from accommodation let in a property may exceed £7,500 where the income is received by three or more people.
The rent-a-room limit is given automatically where the income is below the tax-free limit – it does not have to be claimed and there is no need to complete a tax return.
Decisions, decisions…
Where the income from letting one or more furnished rooms in a home exceeds the tax-free threshold, there are different options available:
- opt into the rent-a-room scheme and claim the tax-free allowance; or
- remain out of the scheme and calculate rental profit in the usual way.
The option which is preferable will depend on the level of associated expenses and whether there is a profit or a loss on the let.
Where the resident landlord chooses to opt into the rent-a-room scheme, the taxable rental profit is calculated by deducting the tax-free threshold (i.e. £7,500 or £3,750 as appropriate) from the rental income.
If the landlord does not want to opt into the rent-a-room scheme, the rental profit or loss is calculated as normal by deducting allowable expenses from rental income.
Where rental income exceeds both the threshold and rental expenses, there will be a profit whichever method is chosen. If actual expenses are less than the tax-free threshold, the best option (i.e. lowest taxable profit) will be achieved by opting into the rent-a-room scheme and calculating the profit by reference to the tax-free threshold. However, if the expenses are more than the tax-free threshold, calculating the expenses in the usual way rather than opting into the rent-a-room scheme will give the best result.
Under the rent-a-room scheme, it is not possible to create a loss by deducting the tax-free amount – where the threshold exceeds the rental income, the taxable profit is taken to be nil. However, if actual expenses exceed the rent-a-room scheme, it is better to work out the loss in the usual way rather than opting into the scheme so that the loss can be preserved and carried forward to be set off against any future rental profits.
Capital gains tax implications
As seen above, letting a room in your own home can be beneficial from an income tax perspective. However, the income tax implications should not be considered in isolation – letting a room or rooms in your home also has CGT implications.
Principal private residence (PPR) relief shelters any gain arising on a property to the extent that it has been the owner’s only or main residence. Where the whole property has been the owner’s only or main residence throughout the period of ownership and a gain arises on disposal, the entire gain is free from CGT.
If the property or part of the property has been the owner’s only or main residence at some point during the period of ownership, PPR relief applies to that part of the gain. The final period of ownership (set at 18 months prior to 6 April 2020, and at nine months for disposal on or after that date) is also exempt. Where all or part of the property has at some time been an only or main residence, lettings relief may be available to shelter any gain arising during periods of letting.
Letting part of the property removes that part of the property from the ambit of PPR relief while it is so let. This may or may not be problematic, depending on whether lettings relief is available to shelter any gain attributable to the let period and, where the gain is not fully sheltered, whether annual exempt amount is sufficient to cover any chargeable gain remaining.
Lettings relief is available where a property that has been a main residence at some point is let. Prior to 6 April 2020, the relief is available regardless of whether the landlord lives in the property or not; however, for disposals on or after 6 April 2020, the landlord must reside in the property with the tenant for the relief to be in point. This means that rent-a-room driven lets will continue to benefit from lettings relief beyond 6 April 2020, as the property must be the landlord’s home to take advantage of rent-a-room relief.
Lettings relief shelters any gain not covered by main residence relief such that the gain is only chargeable to CGT to the extent that it exceeds the lower of:
- the amount of the gain sheltered by PPR relief; and
- £40,000.
If a chargeable gain does arise, the CGT annual exempt amount (i.e. £12,000 for 2019/20) will shelter the gain to the extent that it remains available. Spouses and civil partners can take advantage of the no gain/no loss provisions to put the property into joint names prior to the sale where this is beneficial (e.g. to benefit from a second exempt amount).
Example: Sale of own home occupied with a lodger
Amy has owned a three-bedroom property for three years. She rents out one room furnished for £300 per month. The let accommodation comprises 1/6th of the property by floor area.
On selling the property, she realises a gain of £72,000.
The annual rent from letting a room is £3,600. As this is less than the rent-a-room threshold of £7,500, the relief applies automatically. Amy is able to enjoy the rental income tax-free.
However, the part of the property that is let is not occupied by Amy as her only or main residence and is not eligible for PPR relief. As part of the property is her only or main residence, that part qualifies for private residence relief and, as a result, the final period is also exempt. Assuming that the sale takes place prior to 6 April 2020, the final period will be 18 months.
PPR relief will apply to the gain arising in the last 18 months of ownership and to 5/6th of the gain attributable to the remaining 18 months – a total of 33 months. The property was owned for 36 months. The gain benefitting from private residence relief is therefore £66,000 (i.e. 33/36 x £72,000).
The remaining gain of £6,000 is attributable to the letting. Lettings relief will shelter the full amount of the gain as it is less than both private residence relief and £40,000. Thus, the entire gain will be tax-free.
