Income Tax – UK Owners
It’s just a small word, but it occupies a very important place in the thoughts and nightmares of many of us. It was Disraeli who said that there are only two things in life that are certain…, “death and taxes”. The good news is that you don’t have to be so fatalistic. Like everything in life, you can be a victim or you can make circumstances work for you. It always helps if you have a good accountant to guide you.
I confess that I became familiar with the intricacies of the tax system only belatedly. For years I got by without making a return. Not by any deliberate plan to defraud. But only because he knew he wasn’t making money. My mortgage payments were barely covered by rental income, and having sold no property, there were no capital gains. So why bother the poor overworked civil servants, I thought?
Then house prices skyrocketed! I sold some properties and made some capital gains, investing most of it in property. It was only when I spoke to a tennis friend, who happened to be an accountant, that I began to think that I might need to explore the matter a little more carefully. A holiday in Australia where I took a copy of the Zurich Tax Manual with me as “light reading” convinced me there might be a problem. I think it was the part about ‘tax evasion’ being a prison offense that focused my thoughts. I resolved on my return to come clean. To my astonishment, the tax system was not as criminal or as complicated as I had feared. Now let’s briefly see what are the main taxes that affect a real estate investor.
My tax obligations
Rental property tax liabilities are assessed on the basis of income and capital gains. First, let’s examine how liabilities derived from income are calculated.
All income from land and property in the UK is taxable under Schedule A; which includes residential investments whether furnished or not. Income and expenses for tax purposes are valued as a single leasing business. So effectively, whether you have one property or a hundred, Her Majesty’s Revenue and Customs Service (HMRC) takes the total figure rather than looking at individual properties. Income is assessed for fiscal years ending April 5. Schedule A income is treated as investment income. As such, any loss can only be carried over and offset against Schedule A income and not personal income, such as wages.
Taxable profit is the income that remains after all allowable expenses have been deducted. It’s always helpful to take a quick look at the IR150 ‘income’ booklet at Taxation of Rents for detailed guidance. Like everything these days a copy is available to download from their website http://www.hmrc.co.uk
In essence, your taxable profit is calculated by taking your annual rent and then deducting expenses. For convenience, HMRC separates expenses into 5 categories. These are:
Legal and professional: legal services for a new mortgage, appraisal fees, mortgage broker fees, homeowner’s certificate costs, lease costs, rental agent fees, administrative cost to close on a mortgage, membership fees to a professional body
Repair, maintenance and renovations: redecoration costs, appliance repair charges, plumbing, electrical repairs, etc.
Rentals, fees, insurance, land rentals, etc. -insurance, municipal fees, land rentals
Cost of services provided, including wages: cleaning, meals
Other Expenses: Telecommunications charges, utility bill costs, computer software, advertising costs, purchase of computers (if used exclusively for business) could be counted as a capital allowance (see section on capital allowances below)
What are my allowable expenses?
Repair and renovations
When a property is furnished or partially furnished; Rather than claim as each renewal arises, it is possible to make a single claim for 10% of the rent as a ‘wear and tear’ allowance. This is accepted by Revenue as roughly equivalent to the cost of normal furniture renovations. Beyond the accessories, such as furniture, there will be renovations and repairs in the building, for example, repair of the roof, the bathroom and the windows, etc. This raises a veritable nest of tax wasps. When does a renovation become an improvement? The latter is not an allowable expense against income (although it can be offset against capital gains – see below under Capital Gains Tax (CGT)).
There is, as with many tax issues, a gray area of when a renovation becomes an upgrade. It is largely a matter of fact and degree in each case whether spending on a property leads to an improvement and thus becomes a capital expense. UPVC windows were for many years considered an improvement and therefore the expense counted as capital. However, in recent years HMRC has relented and accepted that UPVC is for most people the modern equivalent of timber and is therefore considered a retrofit.
Another example of how HMRC approaches the issue is its approach to renovating a fitted kitchen. For example, they consider when renovating a kitchen, including work such as removing and replacing base units, wall units, sinks, etc., re-tiling, replacing countertops, repairing floor coverings, and re-plastering and re-wiring. As long as the kitchen is replaced with a similar standard kitchen, it is a repair and the expense can be offset against the income. If at the same time additional cabinets are installed that increase the storage space, or extra equipment is installed; then this item is a capital addition and is not allowable and the additional expense must be contributed as a cost of capital. If standard units are replaced with expensive custom items using high-quality materials, the entire expense is considered capital.
loans and interest
Most people will have borrowed money to finance their investment. When accounting for these costs, only interest payments are an allowable expense. This means that a loan is a repayment mortgage; only the interest element of the loan can be offset against rental income. It is also possible to offset other loans that have been taken for the business. For example, when one has been raised to finance a new kitchen or extension to the rental property. It should be made quite clear in these cases that the loan is specifically for the business and, to the extent possible, documentary evidence should be available (in case income triggers an inquiry). Therefore, if a loan is arranged, try to separate it from your personal finances. This could be done by using it to set up a separate trading account.
So far I have been referring to the tax treatment of a ‘standard’ buy-to-let property rented on a Short Term Secured Tenancy. There are two categories of residential rentals that are treated slightly differently by the Tax Agency. These are where someone rents a room in her house and a furnished vacation rental.
rent a room
Under this system, a person can rent a room in their own home without having to pay tax, as long as the rent does not exceed £4,250 per year. If it is more than this, the taxpayer has the option to have the excess income (i.e. above £4,250) taxed as Schedule A rental gain. Otherwise, the full rent will be taxed as usual on profit from gross receipts less eligible expenses.
furnished vacation rentals
These are treated slightly differently than Income from a standard residential rental. This is due to the amount of management time involved and the relatively short rental periods. Therefore, they are classified as a business and not an investment. Consequently, a different tax treatment applies.
To qualify as a vacation rental the following criteria must be met. The property must be:
* Available for vacation rental minimum 140 days a year
* Actually rented for 70 days a year
* Not occupied by the same person for more than 31 days in 7 months
The main advantage for owners with a vacation rental is that the activity is considered a trade and is assessed under Schedule D. Therefore, any loss can be offset against a person’s personal income, which includes their salary.