Introduction
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 true…, “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 only belatedly became familiar with the intricacies of the tax system. For years I managed without making a return. Not because of any deliberate plan to defraud. But only because he knew he wasn’t making any money. My mortgage payments were barely covered by rental income, and with no property sold, there were no capital gains. So why bother the poor overworked civil servants, I thought?
So 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 I might need to explore the matter a bit more carefully. A vacation to Australia where I took a copy of the Zurich Tax Manual for “light reading” convinced me that there might be a problem. I think it was the part about ‘tax evasion’ being a jail time offense that got me thinking. I resolved on my return to be honest. To my amazement, 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
Tax liabilities for rental properties are assessed based on 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 they are furnished or not. Income and expenses for tax purposes are valued as a single leasing business. So effectively, whether you have one or a hundred properties, HMRC takes the total figure rather than looking at individual properties. Revenues are assessed for tax years ending April 5. Schedule A income is treated as investment income. As such, any loss can only be carried forward and offset by Schedule A income and not personal income, such as a salary.
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’ brochure on Taxation of Rents for a detailed guide. Like everything these days, a copy is available for 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, owner’s security certificate costs, lease agreement costs, rental agent fees, administrative cost to close a mortgage, membership fees to a professional body
Repair, maintenance and renovations: redecorating costs, charges for appliance repairs, plumbing, electrical repairs, etc.
Rentals, fees, insurance, land rental, etc. -insurance, municipal taxes, land rental
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) may be accounted for as a capital allowance (see section on capital allowances to continuation)
What are my allowable expenses?
Repair and renovations
When a property is furnished or partially furnished; Instead of claiming as each renewal comes along, it is possible to make a single claim for 10% of the rent as a ‘wear and tear’ allowance. This is accepted by the Revenue as broadly equivalent to the cost of normal furniture renovations. Beyond fixtures like furniture, there will be renovations and repairs to the building, eg roof, bathroom, and window repairs, etc. This raises a veritable nest of tax wasps. When does a renovation become an upgrade? 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 matters, a gray area of when a renewal 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 considered for many years to be 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 wood and is therefore considered a renovation.
Another example of HMRC’s approach to the issue is its approach to renovating a fitted kitchen. For example, they consider when renovating a kitchen, including such jobs as removing and replacing base cabinets, wall units, sinks, etc., re-tile, replace counter tops, repair 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 income. If at the same time additional cabinets are installed that increase 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 capital cost. 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. In 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 expansion of the rental property. It should be quite clear in these cases that the loan is specifically for the business and, where possible, documentary evidence should be available (in case the income triggers a query). 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.
Non-standard leases
So far I have referred 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 taxes, as long as the rent does not exceed £4,250 a year. If it is more than this, the taxpayer has the option of having the excess income (i.e. over £4,250) taxed as a Schedule A rental gain. Otherwise, the entire rent will be taxed as usual on the benefit of gross income less allowable expenses.
furnished vacation rentals
These are treated slightly differently than standard Residential Rental Income. 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
* It is 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.
