Tax and buy-to-let residential investments

Archive 04.02.2016 Author: Robert Maas

This brief guide is an overview of the tax issues arising in connection with the letting of UK residential property. It does not cover the advantages and disadvantages of using a company or other structure.

Income tax and buy-to-let residential investments

For tax purposes, property income is calculated on the rents receivable during the tax year. You can deduct expenses, but only if they are wholly and exclusively incurred in generating the rental income. You are normally treated as carrying on a single UK property business, so all of the income you receive from letting property in the UK, both residential and commercial, is combined and taxed as one property investment business.

Like any other business, the income from your property letting business must be calculated on an “accruals basis”. This means that the income is the rents receivable during the tax year, not those actually received. For example if you are due to receive rent on 31 March 2016 but do not actually receive it until May 2016, you have to treat it as income of the year to 5 April 2016 (but, of course to exclude it from the income for the year to 5 April 2016). Similarly the expenses that you can deduct are those that relate to the tax year, not those paid during that year.

Start and finish dates

Your property letting business starts when your first property becomes available for letting. In essence the property must be in a condition where it can be let either furnished or unfurnished.

When your property income business ceases will depend on the facts. It will normally cease when you decide to give up renting properties completely. However HMRC is likely to contend that you have ceased when you sell your last property, so if at that stage you are still intending to buy another, it is important to retain evidence, such as a selection of agents’ particulars, to demonstrate that you are actively looking for another investment property. If you are biding your time because you think that the market is temporarily too volatile to invest, you should also try to evidence this. A letter to us explaining in advance your strategy is likely to be good evidence. The timing of the cessation can be important because no tax relief can be claimed for expenses that you incur after the cessation of your business in relation to properties which were formerly let, such as cleaning, council tax, and utility bills.

Tax allowable expenditure – revenue or capital expense

Not all expenses associated with letting a property are deductible from the rental income for income tax purposes. You cannot deduct capital expenditure.  Nor can you normally deduct items not wholly related to your properties.  Qualifying revenue expenses include the following:

  • Advertising for tenants
  • Gardening, cleaning and security services, heating and lights costs, ground rents and service charges
  • Interest paid (but the government intends to limit the relief as explained below)
  • Legal fees for drawing up a short term tenancy agreement or collecting debts
  • Letting or managing agents fees
  • Maintenance and repairs (but not the cost of improvements to the property)
  • Council tax
  • Water rates
  • Accountancy fees for drawing up the accounts of the property business

This is not a complete list. Such expenses can only be deducted where the cost is incurred by you. If the tenant is responsible for paying the expense, such as council tax or water rates, the landlord cannot claim a deduction for those items. You cannot deduct depreciation of furniture or fittings. Nor can you normally deduct the cost of travel from your home to visit the properties, but if you have a portfolio of properties you will normally be able to deduct the cost of travel between the properties.

Repairs

The difference between a repair and an improvement is that a repair restores what was originally in place but an improvement creates something superior to what was there before. As an example, refurbishing a kitchen would count as a repair if the new kitchen is of a similar standard of the one it has replaced. If you replace an item by something superior, it is not necessarily all or nothing; we can normally negotiate tax relief for part of the expense. Replacing part of an item, as opposed to replacing the entire item (which is a capital expense), is a repair, so the costs of  rewiring, re-plastering and retiling are all deductible.

Interest paid

You can currently deduct all the interest paid on loans used to finance your property letting business. The interest is deductible from the rents received as is any loan arrangement fee or similar finance charges. It should be noted that the test is how you use the funds, not what the borrowing is secured on. For example, if you extend the mortgage on your own home to release funds to help to finance your property letting business, you can set off the interest on the extended portion of the mortgage against rents received of the let property, subject to meeting certain criteria.

From 6 April 2020 the deduction for interest and finance charges will be restricted to the basic rate of income tax, i.e. currently 20%. This restriction is being phased in as follows:

 

Tax Year Amount of Interest deductible
2017/18 75%
2018/19 50%
2019/2020 25%
2020/2021 and subsequent years Nil

The mechanics are a little complex but we suspect that most clients will be covered by the following [3] examples.

Example 1

During the tax year 2020/21 you have received a salary of £50,000, property income (taking account of all expenses except interest) of £20,000 and incurred interest on a mortgage on your rental property of £10,000. When taxing income, property income is taxed after salary and so the £20,000 of property income falls within the higher rate tax band and is initially chargeable to tax at 40%.  Accordingly £8,000 of income tax is payable by you in additional to what you have paid on your salary.  The new legislation acts to restrict the amount of higher rate tax relief to basic rate.  So the calculation would be as follows:

Example 2

Identical as example 1 but the tax year is 2018/19. Whilst the new legislation acts to restrict the amount of higher rate tax relief it is being phased in over four years.  In year two you are entitled to 50% of the interest paid as a deduction against the property income.  The balance – in this case the other 50% – is given relief at basic rate as above.

So the calculation would be as follows:

Rental income (net of expenses not interest) £20,000
Less interest £10,000 @50% £5,000
Rental profits £20,000
Tax @ 40% £8,000
Tax relief on restricted interest £10,000 @20% (£2,000)

As you can see the amount of tax payable is less in example 2 than it is in example 1.

Example 3

So what happens when you make a loss? The situation is the same as above except that the rental income is (after adjusting for expenses not including interest) is £5,000 and the interest paid is £10,000.  The tax year is 2020/21 and so only basic rate relief is available.  Furthermore, the amount on which that relief is due is restricted to the profit arising from the rental business and any tax credit is carried forward.

Rental income (net of expenses not interest) £5,000
Rental profits £5,000
Tax @ 40% £2,000
Tax relief on restricted interest £5,000 @20% (£1,000)
Total tax payable on rental income £1,000
Unutilised loss £5,000
Carried forward tax credit £1,000 (£5,000 @20%)

Capital Gains Tax

When you sell a rental property, capital gains tax is levied on the difference between the net sale proceeds and the costs of acquiring and improving the property.

In calculating the gain/loss deductible items of expenditure include:

  • Legal fees on the acquisition and disposal of the property
  • Agent Fees on selling the property
  • Stamp Duty and Land Tax Paid

Expenditure that was not deductible against income because it represented the cost of improvements is deductible in calculating the capital gain. It is accordingly important to retain a note of such income.

Further information

If you would like to discuss these issues further, or any other tax planning opportunities, please get in touch.

About the Author

Robert Maas

Tax Consultant +44 (0)20 7309 3800