Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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March 2003

Q:

I am a self-employed individual with my own home. I recently bought a second residential property (financed by a loan) as an investment. What are some tax considerations of owning a second property?

A:

The 'property boom' has seen many individuals buy second (and subsequent) properties as an investment, and/or to generate rental income (i.e. 'buy to let'). The income from a second (and additional) let property is taxable as a 'Schedule A business'. This broadly means that receipts and expenses from all UK properties are aggregated to produce a profit or loss. The profits taxed are normally those of the tax year itself (i.e. 6 April to the following 5 April), and is dealt with under Self-Assessment. Special rules apply to the UK rental income of non-UK residents.

Working out rental profits (or losses!)

Rental profits are calculated in broadly the same way as self-employed business profits. Expenses must be 'revenue' in nature (e.g. accountancy fees, repairs etc), as opposed to 'capital' (e.g. the cost of the building, surveyors fees and legal fees), and must be 'wholly and exclusively' incurred for business purposes.

• Capital allowances for certain fixed assets are deducted as a business expense. Such allowances cannot be claimed for expenditure on furniture, fixtures and fittings in let residential property. However, a 'wear and tear' allowance may be claimed instead. The calculation of this allowance is 10% of 'net' rents (i.e. rents less payments that would normally be borne by the tenant, such as water rates). An alternative allowances to the wear and tear claim is the 'renewals basis' under which no relief is given for the original cost of furniture, fixtures etc, but a deduction may be claimed for the cost of replacing the asset.
  
  
• Tax relief can be claimed for interest paid on a loan to buy property which is let. The loan interest is claimed as a deduction from rental income. Individuals with a home mortgage often approach the same lender for loans to buy further property. Separate loans (or alternatively separate loan interest certificates) from the lender will make tax-deductible loan interest relief on let property more straightforward to identify and claim (note that no tax relief is due on mortgage interest in respect of the home).
  
  
• The cost of the house itself is capital (i.e. liable to capital gains tax, not income tax), as is the cost of any additions or improvements (e.g. an extension or a new patio). However, if damaged parts of capital items (e.g. kitchen cupboards) are replaced with the nearest modern equivalent of a similar standard, a deduction may usually be claimed. But if they are replaced with expensive, customised and higher quality versions, the Inland Revenue may regard this as capital expenditure and income tax relief could be denied. The taxman does accept that replacing single glazed windows with double glazed equivalents count as expenditure on repairs.

Hopefully, taxpayers with let properties (especially HBA members!) will always find a steady stream of tenants. Unfortunately, in reality this is not always the case, and occasionally rental losses arise. These losses can be carried forward and set off against future rental profits, or can be set off against total income of the same or next following year if they relate to capital allowances or allowable agricultural expenditure.

Selling the property

When residential property (which has never been the main residence) is sold, any gains (i.e. increase in value between buying and selling the property) is normally liable to capital gains tax. This tax is charged on total gains in tax year, less possible deductions such as any Capital losses, taper relief (if available) at the 'non-business asset' rate (unless the property is a 'furnished holiday letting' (see below), in which case 'business asset' taper relief may be due), and the annual capital gains tax exemption. There are also certain 'shelters' from capital gains tax (such as 'Enterprise Investment Scheme' or 'Venture Capital Trust' investments) that could be considered.

In some cases, a gain on the disposal of land can be liable to income tax, not capital gains tax, under certain tax avoidance legislation 'to prevent the avoidance of tax by persons concerned with land or the development of land'. Professional advice in this area is strongly recommended.

Tax Planning for married couples

Married couples may wish to consider owning and renting the let property jointly. This would enable the rental business profits to be divided equally between them (so that two sets of personal allowances and basic rate income tax bands are potentially available to reduce the overall income tax liability). When the property is sold, both spouses may also be able to deduct the annual capital gains tax exemption from any gain on disposal, to the extent that those exemptions have not been used elsewhere.

Furnished holiday homes

Special tax treatment applies to 'furnished holiday lettings'. For example, any loss arising can be set off against other (non-rental) income; profits are treated as earned income for pension purposes; and furnished holiday lettings are generally treated as a trade for the purposes of claiming various types of capital gains tax relief, such as taper relief. However, certain conditions must be satisfied for furnished holiday lettings treatment to apply, and professional advice in this area is once again recommended.

Mark McLaughlin

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