Jennifer Adams considers the tax implications for landlords when renting out a property at a reduced rent or rent-free.
Not all landlords let property to make a profit, be that an income profit or capital gain. There are various circumstances in which a landlord may let at a rate below the current market rate (termed an 'uncommercial' rent) where, for example, a landlord who has otherwise empty properties rents to family and friends at a low rent or even rent-free. The definition of an ‘uncommercial’ let is a property rented for less than the market rate of a comparable property in the neighbourhood.
'Peppercorn' rents are also 'uncommercial'. Until the Leasehold Reform (Ground Rent) Act 2022 was passed, there was no legislative definition of ‘peppercorn’ rent. This Act now defines a 'peppercorn' rent as ‘an annual rent of one peppercorn’. Therefore, such a payment is essentially a small, symbolic rent amount (usually £1) not intended to generate income for the landlord but rather to fulfil legal requirements to complete a lease agreement. Having such an agreement is needed to ensure that there is no risk of the tenant (being the purchaser of the lease) claiming ‘squatters rights’ which could technically legally be possible if no consideration was paid for an extended period.
'Lost’ losses?
HMRC does not have the power to tell a landlord how much rent to charge. Instead, they restrict the amount of expenses claimed against the amount of rent paid. These expenses must have been incurred 'wholly and exclusively' for the property rental business.
HMRC takes the view that should a landlord not charge the full market rent, it is unlikely that this test is met (see HMRC’s Property Income Manual at PIM2010). If any rent is charged, HMRC allows tax relief for expenses up to the amount received, thereby producing neither a profit nor a loss. The downside is that any excess expenses cannot be carried forward against rental income received in a later tax year, even if the property is let at a commercial rate in that year. Therefore, losses incurred on such a property do not exist – it is not that the losses cannot be offset (whether against income on the same property or against income from other properties in the rental business); instead, they are not allowed to arise in the first place. If the property is usually a holiday let and the owners allow friends to stay ‘rent-free’ or at a ‘mates rate’ (i.e., a discounted rate), the ‘uncommercial’ letting rules apply for that period.
The position is different for a property let rent-free. With this situation, HMRC regards such properties as being tax neutral, outside the scope of the property income tax regime and therefore with no deduction for expenses. To be within the regime, there must be a source of income; but there is no source of income if no rent is charged.
Where a property is let commercially some of the time and uncommercially at other times, expenses will need to be apportioned on a ‘just and reasonable’ basis between the two types of lets. Any excess of expenses over rents in the period when commercially let can be deducted in computing profits for the rental business as a whole. However, an excess of expenses over rent when the property is let uncommercially is not claimable.
'Connected persons'
HMRC requires all properties rented to a connected person to be ‘ring-fenced’ should the landlord be in the business of renting other properties and also rents to a ‘connected’ person at less than the market rent or rent-free’. Unrelieved expenses on these properties cannot be offset against profits made on other commercially let properties.
HMRC defines a ‘connected’ person very widely to include a husband, wife or civil partner, brothers, sisters, parents, grandparents, children, grandchildren and their husbands, wives or civil partners, the brothers, sisters, parents, grandparents, children, grandchildren of the husband, wife or civil partner and their husbands, wives or civil partners.
Property allowance
A property rented at less than £1,000 a year will invariably be a property let at an uncommercial rent. However, where rent for all let property owned either as a single rent or part of a portfolio of properties (including foreign properties) is less than £1,000, an allowance is generally available so that the rent is not taxable and non-declarable. The property allowance can be seen to be especially beneficial for the rental of land or possibly a property such as a studio rather than a residential property. It may also prove to be useful where properties are rented on a periodic basis, e.g., under Airbnb lets. The property allowance is in addition to the personal allowance.
Where the total receipts from all properties rented exceed this allowance, an election can be made for partial relief – here, the allowance is deducted from rent receipts. This will clearly be beneficial if the total expenses are less than the £1,000 allowance in any one year.
Replacement domestic items relief
The replacement of domestic items relief (see HMRC’s Property Income Manual at PIM3210) applies to all landlords, whichever type of property, furnished or unfurnished. The rules allow for the deduction of costs incurred for replacing domestic items such as furnishings (although not the initial investment).
A claim under this relief will not usually be available for an uncommercial let as it is unlikely that expenditure on a new domestic item will be deemed to have been incurred 'wholly and exclusively' for the purposes of the trade (see PIM2010). (NB ITTOIA 2005, s 311A specifically excludes a claim for boilers and water-filled radiators that are part of a heating system).
Capital gains tax
The standard capital gains tax rules apply when a property is sold, whether previously let at less than a market rent or not. If the property is residential, and for some of the time of ownership it has been the landlord's only or main residence (regardless of the amount of rent or the connection with the tenant), lettings relief may be due on any gain made.
Despite its name, lettings relief is not available to a property (e.g., a buy-to-let property) which has been let out throughout the period of ownership and which has never been occupied by the owner as their main residence. The relief is only available for periods of letting where the owner occupies the property with the tenant (e.g., where a person lets out a room or rooms in their main residence and continues to occupy). This relief is not available for any period during which the whole residence was let.
The amount of the relief is the lower of the amount of private residence relief (TCGA 1992, s 223), or £40,000, or the proportional amount of chargeable gain arising as a result of that let.
VAT
Letting a property (residential or commercial) is usually VAT-exempt. As such, no VAT reclaim can be made on expenses relating to the let (except for VAT-registered holiday lets), e.g., repairs and furnishings.
In comparison, landlords of commercial buildings are permitted to 'opt to tax', making the rent VAT-able and enabling VAT reclaim on expenses. Although not permitted on residential property, a tax planning opportunity could arise should a residential let be owned by a landlord who is also the owner-shareholder of a VAT-registered company. The 'partial exemption' de minimis rules allow all VAT on exempt purchases to be reclaimed where the claimable amount is less than:
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£625 per month on average; and
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50% of all VAT on purchases incurred in the VAT return period.
If the company is VAT registered, a lease could be granted on the rental property so that the 'partial exemption' limits apply. As the letting will be part of the company's business, all VAT on running costs can be reclaimed even within the de minimis limits.
Practical tip
To ensure that the property retains its ‘business’ status, it must remain available for commercial letting at all times even if used rent-free for a period. The owner needs to prove they are actively looking for tenants – so here we are looking at possibly at least registering with an agency.
