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Jennifer Adams considers the tax implications for landlords when a tenant leaves.

All sources of rental income, be they commercial or residential lettings, furnished or unfurnished, or holiday lettings, are regarded as being derived from the same single property rental business (except for EU lettings, which are separate activities).

Therefore, just because a tenant leaves, this does not necessarily mean that the rental business ceases. A rental business ceases when the last let property in a portfolio has been disposed of, including being gifted (assuming a portfolio of two or more properties).

Should the business comprise one property, a letting business ceases when the last tenant leaves and the landlord decides not to re-let, deciding to sell or live in the property as their main residence, or the property is otherwise taken out of the business (e.g., the landlord may decide to become a trader or dealer, re-developing the property to sell at a profit).

Expenses claims

When a rental business is ongoing and a tenant leaves, the immediate concern for a landlord is the payment of property expenses and confirming that tax relief can be claimed on any expenses incurred between lets.

Tax relief is available on expenses incurred whilst the property is empty and until a new tenant is found (e.g., council tax, water rates, electric, ground rents, etc.) as long as the expenses are revenue in nature being incurred wholly and exclusively for the purposes of the business – including getting the property to a standard such that it is possible to rent. The relief is given against total rental income from all properties whilst a tenant is being sought. The exception is a property let on an uncommercial basis (e.g., if the property is let to a friend for lower than the market rent) where deduction is not possible against profits from other properties but is carried forward and allowed against future income from the same property. If there is one such property and the business ceases, no expenses are allowable after the date the tenant leaves.

However, the situation is slightly different should the tenant break their contract and leave early. Technically, renting under an assured shorthold contract requires the tenant to be responsible for paying rent for the entire fixed term as if they were still residing in the property. However, getting a tenant to pay may be difficult once they have left. In this situation, the water rates and electricity remain the landlord's responsibility; however, the tenant is liable for council tax until a new tenant is found. In addition, most letting contracts include a clause which charges the leaving tenant with the cost of readvertising, payment of which usually comes out of the deposit, if any amount remains after redecoration etc.

What is the tax position regarding a deposit?

If renting on an assured shorthold tenancy, any deposit (if taken) must be placed with a government-approved tenancy deposit scheme. Sometimes, the cost incurred in returning a property to a lettable standard may require deductions from that deposit following the tenant leaving.

If payment is granted under the scheme, the amount is shown as income in the letting accounts. If the expenses exceed the deposit amount granted, the landlord can go to court to recover the balance (court time is currently taking around 50 weeks). Should the court agree to an additional amount, it is taxable in the year of receipt.

Gaps between lettings

Invariably, there will be a gap between lettings whilst a new tenant is being found. Whether cessation has occurred in such a scenario will depend on several factors, the first being the length of the gap.

HMRC’s Property Income Manual (at PIM2510) states that they will not normally argue that there was a cessation, provided the gap is less than three years and the landlord can prove that they were trying to re-let in the meantime. More than three years and 'convincing evidence' would be needed to prove the continuation of the same business. HMRC will also look to see whether the same property is let before and after the break in letting and whether the activities of the rental business are the same before and after the dormant period (e.g., paying a management charge to a letting agent).

Post-cessation expenses

Where a tenant leaves and the business ceases, any receipts received within seven years of the business ceasing are taxed under separate rules as that business no longer exists. If the landlord has suffered post-cessation expenses, these cannot be backdated but are set against post-cessation receipts initially, if any. If there are no receipts, sideways relief is possible against other general income, with any balance remaining offset against any capital gains accruing in the same year.

Such payments include the remedying and claiming of damages for defective work undertaken in the course of the former property business, debt collection expenses and the writing off of a bad debt originally charged to income tax (although this latter cost is not strictly an expense, the legislation treats the payment as such).

If the business ceases because the property is being put to private use and expenses are incurred (e.g., changing the décor for personal taste in preparation for use as a residence), deduction is not available as the expenses have not been incurred for the business, as the business has ceased.

Income vs capital expenses

If the landlord takes the opportunity after a tenant has left to repair the property before re-letting, the question as to whether an expense comes under the income tax or capital gains tax rules is sometimes difficult to ascertain. A ‘capital improvement’ goes beyond a repair where the expense enhances the value of the overall asset – usually the property itself. An example can include the cost of replacing a garage that has been falling down.

Expenses will be allowable against income if they constitute repairs or the replacement of part of an asset. Examples include replacing kitchens and bathrooms, re-wiring, decorating, repairing roofs and gutters, etc. HMRC accepts that items such as mending broken windows, etc., are usually repair works.

Where a lot of work is undertaken at the same time, this may comprise both repairs and improvement expenditure (e.g., an existing roof may be repaired at the same time as building an extension). The costs of repairing the roof would be deductible as a revenue expense.

Commercial property differs, and repairing may be of numerous individual assets, such as kitchen units, boilers, radiators, sinks, etc. In that case, each cupboard could be an asset in its own right, but unlike in ordinary residential lettings, could be eligible for capital allowances.

HMRC will sometimes argue that repairs undertaken alongside improvements are just part of a greater scheme of capital improvements, and everything should be disallowed. This might be the case when replacing kitchen units with substantively higher-quality units; the improvement cannot be separated from the replacement – each item is better quality.

The importance of the cash basis

If the expense is incurred whilst there is a 'gap' in renting and accounts are prepared on a cash basis, there is no differentiation between capital and revenue expenditure. However, in practice, most capital expenditure on residential letting is disallowed under the income tax rules unless qualifying for replacement of domestic items relief in a property that is let furnished as long as the replacement is on a like-for-like basis. Capital allowances can only be claimed where accounts are prepared under the 'accruals basis'.

 As a reminder, where an individual landlord’s annual turnover (gross rents) is less than £150,000, the default accounting method is the cash basis. Companies, limited liability partnerships, trustees and personal representatives (who can all be landlords) and those individual landlords with gross rents in excess of £150,000 are required to use the ‘accrual’ basis of accounting.

Practical tip

As ever with any expense claims, receipts should be kept; but with regard to rental property, retention should be until the property is sold, rather than the usual six years. This is particularly relevant where expenses have been incurred but not deducted as income expenses as it may be possible to offset under the capital gains tax rules.