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TaxationWeb by Steve Sanders

Steve Sanders of Tolley Tax Training considers the tax implications of a popular form of investment for many taxpayers.In recent times, many people have decided that pensions are not the only way to provide funds for retirement, and have sought alternatives. Buying property, in many cases, tops the list.

In this article, I will explore the tax implications of buying property with a view to letting it out and/or eventually selling it.

Income tax

Letting property produces rental profits which will be chargeable to income tax. Rental profits are broadly rents receivable (using an “accruals” basis) less allowable expenses. Expenses are allowable provided they are incurred “wholly & exclusively” for the purposes of the letting business.

No relief is given for capital expenditure such as improvements to the property or new fixtures & fittings etc. What the landlord may see as genuine “repair” expenses to make the property suitable for letting in the first place are also disallowed under the Law Shipping decision.

Capital allowances can be claimed on plant and machinery for maintaining the property (ladders, lawnmowers etc). Otherwise wear & tear allowances compensate the landlord for the dilapidation of furnishings, and are available at 10% of the rents (after deducting water rates and council tax borne by the landlord). A renewals basis for replacing furniture can be claimed instead of “wear and tear”, although wear and tear is generally the preferred option.

Interest relief is given for loans taken out to purchase the property. For companies, interest relief is given as a DIII deduction rather than reducing the letting profits. For taxpayers with a mortgage on their main residence who thereafter have some spare capital and wish to “buy to let”, sensible restructuring of the loans should ensure that loans outstanding relate to the rental property to secure tax relief for the interest.

Profits and losses from all UK properties are “pooled”. There is no “mixing and matching” with profits / losses on overseas properties. Net profits from the letting business are taxed as non-savings income (22% in the basic rate band, 40% thereafter). There is no national insurance (NIC) as the income is not “earnings”.

Profits are split if the properties are jointly owned. Consideration should be given to registering the properties in joint names to make use of spouses’ personal allowances and basic rate bands.

Net losses are carried forward and relieved against future rental profits. There is no set-off against general income, so loss relief is restricted. Relief for losses is only available if the letting is on a commercial basis.

Companies relieve rental losses automatically against other profits chargeable to corporation tax. Excess losses are carried forward or group relieved.

Do also remember, that basic rate taxpayers who start letting properties, may be required to give notice of chargeability to the Revenue within 6 months of the tax year in which the letting commenced. Letting a property will bring a new landlord within the self-assessment regime, unless returns are already being filed.

If the landlord is non-UK resident, there is still a liability to income tax on UK rental profits. In this instance, the tenant (or agent if one is in place) is required to withhold basic rate tax at source unless the landlord has received authority from the Revenue to receive rents gross. Application for gross payment will be looked at sympathetically if the landlord agrees to file self-assessment returns and has a healthy filing / payment record.

Furnished holiday lets (FHLs)

If the letting satisfies certain conditions, it will be classed as a FHL and tax advantages accrue. A property will be a FHL if it is:

1. Available for commercial letting to the public for 140 days in a year; &

2. Actually let for 70 days in that period; &

3. Not let to the same tenant for a continuous period exceeding 31 days.

The property must be furnished and situated in the UK. Despite the word “holiday” in the title, there is no requirement for the property to be near the seaside. A flat in the city let out to sightseers could qualify.

The advantages of having a FHL are numerous.

1. Profits are relevant earnings for pension purposes, thereby enabling property owners to make larger tax-deductible pension contributions;

2. Losses on FHLs can be relieved in the same way as trading losses, ie, against general income in either the current or preceding year;

3. Capital allowances (including first year allowances) are available on fixtures and furnishings. These replace wear and tear allowances;

4. FHLs are “business assets” for all aspects of capital gains tax (CGT). A sale of the property after more than 2 years will therefore qualify for the maximum rate of business taper relief causing 75% of the gain to disappear. Gift relief and roll-over relief are also available if the FHL is gifted or sold then replaced.

There have been recent discussions about whether FHLs qualify for business property relief (BPR) for IHT purposes in the event of a death or chargeable transfer. The answer seems to be “it depends”. If the lettings are short-term (weekly / fortnightly) and the landlord is actively involved in running the FHL “business”, Revenue Capital Taxes accepts that there is little distinction between a FHL and a hotel or bed-and-breakfast. In this instance, a strong case can be made for BPR to be given.

“Rent-a-room”

Relief is given for renting out a room in one’s main residence. Under the rent-a-room scheme, rents from lodgers in one’s home are only taxed to the extent they exceed £4,250 per tax year. The relief applies per property (not per room or per lodger). The exemption cannot be used to create a loss. Expenses of letting are ignored. The scheme is not applicable to the letting of a room used as an office or for the purposes of a trade.

Landlords can choose to use the normal rules to determine the taxable profit (or allowable loss), but this will involve a reasonable apportionment of expenses and perhaps some wheeler-dealing with the Inspector.

An added advantage of the rent-a-room scheme is that principal private residence (PPR) relief is not jeopardised when calculating gains on sale. If rent-a-room relief is not claimed, the gain attributable to the part of one’s property being let will be chargeable. Lettings relief is available, up to a maximum of £40,000.

Capital gains tax

There will come a time when the market or other factors dictate that the property should be sold enabling the landlord(s) to enjoy the capital profit. At this point, thoughts turn to CGT.

Any “capital” costs disallowed when calculating annual rental profits, may be allowed to reduce the gain on sale. These will include legal fees and stamp duty land tax incurred on purchase, and any subsequent capital expenditure on the property which has enhanced its value and is reflected in the state of the property at sale.

Taper relief is key in determining the chargeable gain. The rate of taper depends on whether the property qualifies as a “business asset”. There is a misconception that just because a property is being let out, it is by definition a non-business asset. Wrong. It is likely to be a business asset if it is being let to a business.

If the property is let as residential accommodation, it will be a non-business asset (unless qualifying as a FHL). The chargeable gain is thereby reduced by 5% per annum once 3 years of ownership have elapsed. For pre-March 1998 properties, the qualifying period increases by a 1-year “bonus”.

If the property is being let to a trading business, the gain will probably qualify for business taper. From April 2000, a property will be a business asset if it is being used by;

• An unlisted trading company; or

• A trading company in which the owner had at least 5% of the shares; or

• A trading company in which the owner works.

Note there is no requirement for the property owner to hold shares in the unlisted trading company using his building. Before April 2000, the owner either had to have 25% of the shares, or hold 5% and work full-time for the company. This has been relaxed from April 2000.

With effect from April 2004, the definition has been extended to include properties let out to unincorporated businesses with which the property owner has no connection. Until 5 April 2004, the owner had to use the building in his own sole trade (or partnership) to qualify for business taper relief. Apportionment of gains may be required where property owners were letting to sole traders / partnerships before April 2004.

IHT

Leaving property to pass via the Will has the advantage of washing-out capital gains as assets pass at probate value to the nominated beneficiaries. However, the value of the property will instead be included in the death estate and charged to IHT.

Relief is available for business or agricultural property. Properties will qualify for BPR if let to a company controlled by the owner or a to a partnership in which he/she was a partner. In this case, BPR is given at 50%. Properties let to unconnected businesses will not be eligible for BPR.

Farmland or farm buildings will qualify for agricultural property relief (APR) if let to a tenant who uses the land for farming purposes. Relief is available at either 100% or 50% depending on whether the lease was signed before/after September 1995 and how long the lease had to run at the date of transfer. For APR to be given on tenanted properties, the landlord must have owned the buildings for at least 7 years (rather than 2 years under general rules).

Value Added Tax

In most instances, there is no requirement for a landlord to charge VAT on rents.

If a VAT registered trader lets out a commercial property, this is an exempt supply so VAT is not charged on rents. However, the trader now has a mixture of taxable and exempt supplies, thereby making his business partially exempt, and potentially causing problems with recovery of input tax.

The trader might then consider electing to waive exemption (“opting to tax”) on the property. This makes the letting a taxable supply, causing rents to rise by 17.5% but allowing full recovery of input tax. This is only a problem for non-VAT registered tenants who cannot recover the VAT paid.

VAT would thereafter need to be charged on the sale of the building.

Steve Sanders
August 2006

Steve Sanders is a senior tax tutor at LexisNexis Tolley Tax Training which provides quality tuition for the ATT, CTA, AIIT and ADIT exams as well as in house and public CPD training services.

"LexisNexis Tolley® Tax Training" provides quality correspondence, classroom and e-training for the ATT, CTA, AIIT and ADIT examinations. In addition their e-learning package "Tolley’s Tax Tutor" is excellent preparation for anyone studying tax for any professional examination (ACCA, ICAEW, ICAS, AAT etc). For further information please click the following link: www.tolleytraining.co.uk or email your query to taxtraining@lexisnexis.co.uk