Meg Saksida looks at some potential problem areas in tax for property landlords.
If a landowner exploits their UK land to generate rental income, whether it is bare land or the letting of commercial or residential property, whether it is profitable or running at a loss, it will be defined in law as a receipt of rental income. The income is generated through the operation of a rental business which is taxable in the UK, irrespective of whether the landowner is UK resident or non-UK resident. In addition, UK resident landlords with offshore rental income will be taxed in the UK using the same principles.
Getting the tax right can sometimes be a challenge, and some areas are at more risk of error than others.
Who owns the property?
Where the let property is owned by an individual, all the net profit will be taxable on that taxpayer. In cases where the property is held jointly, on the other hand, the split of the receipts and expenses will need to be carefully checked and matched with either the 50:50 default (if the couple is legally bound) or the election for the beneficial ownership per HMRC’s Form 17 (which requires proof of their share owned). If the couple is not married or in a civil partnership, the split will be 50:50 unless any other split is desired.
This is an area which could easily be calculated incorrectly; such miscalculations could benefit couples on whom differing rates of income tax are charged.
Ensuring income is adequately defined
Landlords need to ensure that all income from the exploitation of their land is declared.
A formal let using a ‘short-term assured tenancy agreement’ is generally recognised to be taxable income, but even one-off casual letting for (say) a couple of days or a weekend is characterised by HMRC as a property business. Deposits and ‘bonds’ are also a form of taxable rental income.
The rent-a-room scheme
Where taxpayers have another individual living in their home they can use the rent-a-room scheme, meaning that no tax or disclosures must be made (unless a contrary election is made) for income under £7,500.
However, once the income exceeds this threshold, the landlord must choose between the rent-a-room standard tax-free amount or the actual net profit generated. This is frequently misunderstood.
Ensuring all types of payments are disclosed
Not only is income that enters the landlord’s bank account (on, say, a direct debit) or is passed to the landlord in cash taxable, but all forms of payment are counted as taxable rents, even payments in kind.
For example, if a tenant cultivates the garden of the let property in exchange for a lower rent, the value of the gardening is rent ‘in kind’ and disclosable and taxable as rental income of the landlord.
Ensure property business profits are kept separately
All UK property rental businesses are one property business of the landlord for taxation purposes. This means the landlord can offset losses on one property against gains on another (although if one or more of the properties is let as furnished holiday accommodation, there are separate rules). All overseas property letting is another property rental business for taxation purposes, and the rules above are mirrored.
Landlords must be clear, however, that losses cannot cross over from one separate business to another. Further, property rentals that compute a loss due to being let at less than market rate (usually to family or friends) are restricted in the level of expenses that can be offset for tax purposes, and as such, any losses generated on this type of lettings can never be used.
Capital vs revenue expenses
It is always a tricky area to differentiate capital and revenue expenses, especially when the expense has a dual private and business purpose. If there is no way to establish which is the private and which is the business part of the expense, no deduction can be made.
For example, a landlord buying a smartphone for both private and landlord business use cannot say the top half of the phone is private and the bottom business. However, the calls, if they are charged individually, can be differentiated such that the cost of the business calls will satisfy the ‘wholly and exclusively’ rule and therefore be deductible and the private calls will not.
Distinguishing whether the entire expense is capital or revenue can also be difficult. Is the payment purchasing a new asset or increasing the capital value of an existing asset (capital), or is it simply maintaining an asset already owned (revenue)?
Capital allowances
Capital and revenue differentiation is crucial; generally, capital items cannot be offset against income in calculating taxable profits. However, capital allowances provide for a percentage of the capital value of the asset to be deducted over time. For residential landlords, this may include such items as garden tools, ladders, or motor vehicles. For non-residential landlords, other plant and machinery is also eligible. Again, this is not well understood.
Residential landlords (not those under the furnished holiday lettings rules) can use the ‘replacement of domestic items’ relief, which allows them a full deduction for the cost of replacing the item such as a sofa, bath, or washing machine, but there is no deduction for the initial purchase.
Interest payments
Integrated fully in the 2020/21 tax year, landlords are no longer able to offset finance costs and enjoy higher or additional tax rate deductions on them.
The process of deducting the finance costs is counter-intuitive to non-tax experts, as the profits are to be included without the finance costs having been offset, and then a ‘tax reducer’ is used to decrease the tax charge by the basic rate applied to the finance costs. This is often misunderstood and has been flagged as a risky area by HMRC.
Using the correct computation basis
In the UK, if a property rental business has income of £150,000 or less, the taxpayer by default can use the infinitely simpler ‘cash basis’ rather than apply the more complicated generally accepted accounting principles (GAAP) through the ‘accruals basis’. If a taxpayer prefers the accuracy of the accruals basis, it can be opted for as a choice by those that have income of £150,000 or less.
Occasionally, taxpayers will need to (or want to) change the basis on which they are working. For example, if rental income surpasses the limit, the cash basis will need to change to the accruals basis. Transitional adjustments may be required to ensure that the landlord has not been taxed on the profits more than once and that they have received the deducted for expenses, but only once. These adjustments are not well understood.
Can you use the property allowance?
The property allowance is an amount of £1,000 which can be deducted from property income. If the property income is £1,000 or under, no disclosure is required, as the profits would be nil.
Like the rent-a-room issue defined above, once the income exceeds this minimum amount, the landlord must choose between the property allowance’s standard tax-free amount or the actual net profit generated. There are also some restrictions with the property allowance, such as it being not available if any of the rental income comes from a connected party.
Practical tip
The risky areas tend to be where the landlord has engaged in a more complicated letting than normal, such as accepting rental income in kind, letting to family, or changing the basis on which the profits are taxed. However, one of the recurring problems HMRC sees is landlords not realising that their profits are to be apportioned and calculated from 6 April to 5 April every year.
