Tax treatment of rents related to a trade or profession

Sarah Bradford looks at the treatment of rents related to a trade or profession and explains when rents may be treated as trading income rather than property income.

A trade or profession will generally be carried on from business premises. There may be times where the business does not utilise their premises in full and opts to let out the surplus accommodation. 

Where this is the case, the trade or profession can, if certain conditions are met, treat the rental income they receive from the let of surplus business accommodation as a trading or professional receipt, rather than as income of a property rental business. 

This treatment can only be adopted if the following conditions are met:

Rent receipts can only be treated as trading receipts where the accommodation is temporarily surplus to business requirements. If, by contrast, the business acquires accommodation which has more space than they need for their own business requirements with a view to permanently letting the excess, the associated rental income would be taxed as property income rather than as a trading receipt. 

To meet the legislative conditions, the accommodation is regarded as ‘temporarily surplus to requirements’ if:

If these conditions are met at the beginning of a period of account, the accommodation continues to be treated as being temporarily surplus to requirements to the end of the period of account. 

A further point to note is that this treatment only applies where the property is used partly for the business and is partly let – it does not apply where the surplus accommodation is a separate building. In this case, the rental income must be dealt with as property income, rather than treated as a trading receipt.

The legislation requires the rental income receipts to be ‘relatively small’ for them to be treated as a trading receipt. However, what constitutes ‘relatively small’ is not defined in the legislation; nor do HMRC throw any light on how they interpret the phrase in the guidance, published in their Property Income manual at PIM4300. Consequently, a normal, everyday meaning is applied. 

Where receipts from the letting of surplus business accommodation are treated as trading income, the rental receipts do not form part of the landlord’s property rental business. Consequently, any expenses incurred in relation to re-letting of the surplus accommodation are deducted in computing the trading profits.

Tommy is a potter, operating from a barn which comprises studios, a kiln, office space and a small show room. For the last five years, he has employed an assistant, who works on separate pieces in another studio. His assistant takes a 12-month sabbatical in order to travel and Tom lets out the studio for the period while it is not being used. 

The studio meets the definition of accommodation that is temporarily surplus to the requirements of the business. It also satisfies the other conditions for the rental income to be treated as trading income. Consequently, the receipts received from letting the studio in the assistant’s absence are included as trading receipts when computing the trading profits of the business.

Mandy is a hairdresser. She acquires the lease on a property, with a view to running the salon from the ground floor and sub-letting the first floor to provide an additional source of income. She finds a tenant, letting the floor to a beauty salon. 

As the first floor does not meet the definition of accommodation temporarily surplus to requirements, the rental income is treated as property income and taxed accordingly. It is, therefore, excluded from the computation of trading profit, as are any expenses associated with the letting.

It should be noted that it will not always be preferable to include the letting receipts as trading receipts – if the landlord has a property income business which has brought forward losses, treating the receipts and property income receipts rather than trading receipts will allow those losses to be used.

As noted above, receipts from letting surplus accommodation in the same property as that which is used for the purposes of the business may, in certain circumstances, be included in trading receipts. However, where the surplus accommodation comprises a separate property, this treatment is not available, and the receipts are treated as receipts of the property income business and taxed according to the property income rather than trading income rules.

If the separate property ceases to be used for the purposes of the business but is not sublet, the business will usually be able to deduct the expenses associated with that property, such as rent, business rates, utility bills, etc. The test is determining whether the expenses are deductible if they undertook the rental obligations of the surplus property ‘wholly and exclusively’ for the purposes of their trade or profession. 

Expenses must be ‘wholly and exclusively’ incurred for the purposes of the business if a deduction is to be permitted in computing the taxable profits of the trade. This test is normally met where a taxpayer enters into a lease in order to use the property in their trade or profession – for example, where a trader rents a unit on an industrial estate from which to run the business. However, the deductibility test is not met in relation to expenses incurred in respect of a private property, or one which is let out as part of a property rental business. 

Where a property which has been used as part of the business becomes surplus to requirements, the expenses will cease to be deductible in computing the trading profits if after it has become surplus to requirements, the tenant renews the lease in order to continue subletting the property or fails to exercise an option to terminate the lease once it is no longer required for the purposes of the business.

Where the separate property is sublet after it becomes surplus to requirements, the strict position is that any rental receipts are taxed as rental income with no deduction for expenses that qualify as expenses of the trade and profession. However, if preferred, the trader can deduct the expenses in working out the rental profit rather than the trading profits, so the net rental profit is charged to tax as property income. Where expenses in relation to the property exceed the rental receipts, any surplus of expenses can be deducted from the trading receipts in computing trading profits, as long as the ‘wholly and exclusively’ test is met. This will prevent a property income loss from arising, which may be wasted, allowing the expenses to be relieved immediately where there is a trading profit. 

Property dealers and developers holding property as trading stock may temporarily let the property, for example, during a downturn in the property market when it is difficult to sell or to sell at a profit. 

In this scenario, the rental receipts are treated as receipts of a property income business. Expenses are first set against the rental profit, with the net profit being taxed as property income. However, any excess of letting expenses over the rental receipts can be deducted as trading expenses of the property dealing or property development trade. If the trading stock is not let, the associated expenses are deducted as trading expenses (as long as the ‘wholly and exclusively’ test is met).

Where a business has rental income from letting business accommodation, the treatment will depend on the circumstances. It is important to appreciate the rules and ensure the rental receipts are treated correctly.