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Rajesh Kohli BSc ACA introduces taxpayers to accounting concepts relating to the taxation of rental income.

The Principle of Trade: Taxation Treatment of Property Rental Income

The taxation treatment of UK property rental income is not always clear. As more and more UK residents hold more than just the one property and expand their investments to overseas property holdings, including selling properties in their portfolio, the taxation treatments concerning these income streams can sometimes seem like a minefield.

This can be especially confusing when you consider that properties can become subject to both income tax on property rentals and possible capital gains tax on a property sale.

Below however we confine our comments to the taxation treatment of property rental income.

Treatment as a Trade

Landlords do not always appreciate that HM Revenue & Customs (HMRC)  treat a UK rental property as if it were any other trade. The significance of treating income in this way means that all income in the tax year is calculated on the principle of “accruals accounting” or on an “arising basis”.
 
In practical terms, this means that income is assessed on what is due in the year and not necessarily what income has actually physically been paid over by the tenant. For example, if a tenant per the tenancy agreement is obliged to pay £495 a month, the taxable income is £5,940 a year, irrespective of how much is physically collected from the tenant.

Pooling of the Property Portfolio

Since rental income is assessed like a trade, all income from the different rental properties is pooled together, creating one income stream. Hence profits and losses of the same UK properties are amalgamated together to create an overall net profit or loss. In essence, losses from one property are netted off against profits of the others.

If after pooling all properties together there is a loss, then these losses can be carried forward against future profits. These losses cannot be set off against other income, e.g. employment income or self employed income. However, if losses arise due to “capital allowances” this may then be relieved against other general income

Capital allowances are basically allowances that are given for the decrease in the value of assets on an annual basis that are used in the property. For e.g. fridges and ovens.

Capital allowance rates may be 20% or 25% a year, depending on the tax year being considered.

Generally, expenses are allowed to be deducted if they are incurred “wholly and exclusively” for the purposes of the property business. The treatment for limited companies broadly follows the above same rules as for UK individuals.

Rental Income under-declaration: Principle of Trade

Following the principle of trade, tax inspectors enquiring into property rentals are therefore particularly interested in reconciling the rents as stated in the tenancy agreement to those declared on the tax return.

Many landlords declare the rental income they have actually received into the bank or by the tenant in cash, without reconciling the total rent to that detailed by the tenancy agreement. Landlords may not appreciate the principle of accounting for rental on an “arising” or “accruals” basis, as discussed above.

Due to the disregard of this taxation treatment, declared rental incomes on the tax returns tend to fall far short of that per the tenancy agreements. This can be due to several factors, including:

• late payments
• disputed payments
• tenants leaving early
• tenant improvements being netted off the rent received, and more commonly
• the deposit being used to pay the final month’s rent.

Any one or more of these factors can create a whole host of undocumented possibilities that the HMRC Inspector will be looking to seek and assess undeclared income on.

It is therefore imperative that rental incomes are checked to tenancy agreements and a full log made of acceptable differences for which backup evidence is held.