TAX IMPLICATIONS WHEN BUYING PROPERTY

I am thinking of buying a property to let out - what do I need to know?

To give you a starting point, you’ll need to ask yourself several questions, including:

• Will I buy with cash or do I need a mortgage?
• How much will it cost?
• How much rent will I charge?
• Am I letting solely or jointly?
• Am I going to let residential or commercial property?
• Do I want to be a hands-on landlord or will I use an agent?
• Will the property be let furnished or unfurnished?
• Is it located in an area which is likely to see a general increase in house prices?; and
• Do I want to let the property to long-term tenants, or will it mainly be short-term holiday lettings?

This may seem like a lot to consider at the outset, but as you will see, different answers will make a great deal of difference to your tax position one way or another.

The first tax that you will encounter when buying a rental property is stamp duty land tax (SDLT) or, if the property is in Scotland, land and buildings transaction tax (LBTT). Since 6 April 2018, Welsh land transaction tax applies to purchases of property located in Wales.

 

What is land tax?

SDLT is a tax on value charged to you (the buyer) when you purchase a property. It is therefore a real additional cost of purchase. You need to consider what the SDLT charge will be when budgeting for a purchase and you’ll need to have the amount ready upfront along with your solicitor’s fees for conveyancing.

Make sure you keep the paperwork for both the solicitor’s fees and the SDLT charge for later on - as they are incidental costs of acquisition, you are allowed to add them to the purchase price when working out what your taxable gain is on a later sale.

Despite the name, SDLT, and the Scottish and Welsh equivalent, can also apply to lump sums paid for leases and rental contracts - you don’t actually have to be purchasing land.

The current SDLT bands and rates for residential property are:

Rate bands that apply to purchase price	Rate payable on part of price within each band
First-time buyers (on properties costing no more than £625,000)
First £425,000	Nil
Between £425,001 and £625,000	5%
Other buyers
First £250,000	Nil
Between £250,001 and £925,000	5%
Between £925,001 and £1,500,000	10%
Over £1,500,000	12%
Over £500,000 (where purchase is made by corporate body)	15%

 

There is a 3% surcharge applicable to "additional properties". This applies whenever the buyer has an existing legal interest in residential property, so will almost always apply to a buy-to-let landlord. Properties costing less than £40,000 are exempt from this charge - but obviously this means that properties that don’t attract SDLT at the main rates can be caught. It’s hard to see how any property, other than a serious fixer-upper bought perhaps at auction, will fall below this value.

Note. We are using SDLT to illustrate the land tax here. The devolved equivalents in Scotland and Wales operate in an almost identical way, but have differing bands and rates.

 

I heard it’s really tax efficient to take in lodgers. Is this true?

It can be, yes. If you let a room to a tenant in your own home, rent-a-room relief is available. The house does not have to be owned by you. You could rent it and then sublet a room to a lodger, subject to the terms and conditions of your tenancy agreement.

The rent-a-room limit is currently £7,500 per year. Any gross rent up to this limit is tax free. If your gross rent (rental income before deducting costs) is less than the limit, then you will have no tax to pay.

If your tax-deductible expenses exceed the gross rent, i.e. you make a loss, you can elect for rent-a-room relief not to apply. That way, the loss can be carried forward and deducted from rental profits in later years.

If the rent-a-room receipts exceed the limit then by default you will be taxed under the normal rental income rules, with income less expenses.

You can, however, elect for the rent-a-room relief to apply as a flat rate deduction, so that the gross rent in excess of the limit is taxable.

The time limit for both elections is twelve months from 31 January following the end of the tax year in which the election applies.

When your gross rent does not exceed the limit, then the relief applies automatically as it is the best option for you. However, if the rent from the lodger exceeds the limit, then the election to claim rent-a-room relief, mentioned in the tip above, can be made. This can be done by ticking a box on your tax return or sending a standalone claim to HMRC within the time limit.

This relief applies to each property and not each tenant. So should you have two tenants, the rent-a-room limit is still £7,500 in total.

If your property is jointly owned by two or more people, then half of this amount, i.e. £3,750, is given to each owner. This is irrespective of the actual rent apportionment.

CALCULATING THE TAXABLE PROFIT

How is my rental income taxed?

Your rental income is basically a specialised type of business activity. As such it is charged to income tax on a profits rather than turnover basis. This means that you are entitled to deduct allowable expenses from your gross rent receipts, and only pay tax on the bottom line number. The rules on how you calculate this rental profit are based on both legislation and case law. Your rental profits are pooled and taxed as a single business. Any overseas let properties are treated as a separate business.

If your gross rent receipts do not exceed £150,000, then by default you will be taxed on the cash basis (applicable since 6 April 2017) meaning that you only include income and costs that you actually receive or pay out in the tax year. This can simplify things as you don’t have to time apportion rents and costs.

Example

Joe arranges with his letting agent to pay five years of management fees (£7,000) in one go in advance at the end of March 2023. He calculates his rental profits on the cash basis as his gross receipts are not in excess of £150,000, and for 2022/23 his profits are reduced from £10,000 to £3,000 by including the payment.

 

Are there any exceptions to this?

Yes - if your gross receipts exceed £150,000 in any year, or if you opt out of the cash basis. Instead, your rental profits will be calculated on the accruals and matching basis. This means rents are taxed in the tax year the rental period payments relate to, not the date the payments are actually received. For example, should rent be payable on the first of every month, there will be twelve taxable payments of rental income in the tax year. You can’t therefore delay a tax bill by asking your tenant to wait until 6 April 2023 to pay their rent for the quarter ended 31 March 2023 as the payment will be matched to that quarter.

 

What if my tenant does not make a payment?

If your tenant doesn’t pay you, the unpaid amount is treated as a bad debt and this amount is deductible against rental income. Of course, if they simply pay late, or if you later recover unpaid rent from them, you will need to include this in your rent for tax purposes.

 

Does a deposit count as income?

Not initially - remember that under tenancy law you cannot actually use the money received as a security deposit, and it needs to be placed in a government authorised scheme (e.g. the deposit protection service). At the end of the tenancy you need to inspect the property and, if there is any damage, agree with the tenant on any amount you are going to retain from their deposit to cover repairs. Any amount retained does count as income and so you will need to include it.

 

What costs can I deduct?

Remember that your property letting is a form of business, and therefore the rules which apply to businesses in respect of allowable costs must be adhered to. HMRC confirms that costs must be incurred wholly and exclusively for your letting business in order for you to be able to deduct them from your rental income. This means expenses that are used partly for the property business and partly for personal/other use are not allowable, unless they can be clearly separated into business and non-business amounts. Some common types of expenditure are given in the table below. We will discuss the categories, which can be tricky, in more detail.

Type of expense	Example
Letting agent fees	Fixed % deduction from gross rent by agent
Advertising costs	Charge by agent for including property on their website
Repairs and maintenance	Amount paid to a handyman to fix leaking roof. See below for further information
Ground rent	Amount paid to owner of freehold interest under sublease agreement
Insurance premium	Annual cost of landlords’ insurance renewal
Mortgage interest	No direct deduction is available, but a financing cost tax reducer is available.
Gas safety checks	Cost of engineer’s annual certification
Smoke alarms	Cost of equipment and installation, as well as testing
Legal and professional costs	Amount paid to accountant for producing taxable rental accounts - note the cost of preparing your personal tax return is not allowable - ask for a breakdown on your invoice
Telephone and postage costs	Calls and correspondence with the tenant and letting agent - either use a dedicated phone or at least ensure an itemised bill is received
Travel	Mileage at approved rates on travel incurred exclusively for the purpose of the rental business - e.g. driving to inspect the property at the end of the tenancy, with no personal travel involved
Rates (if paid)	Costs of council tax, water, electricity, gas, TV licence etc. where cost paid by landlord
Cost of replacing furnishings	Replacing a washing machine. See below for further information.

 

These examples are not comprehensive. A good rule of thumb is to ask yourself whether the expense was incurred specifically for the property. If it was, it’s likely that you are allowed to claim it.

 

Can I claim the cost of building an extension?

No, capital costs like this generally can’t be deducted against your rental income. Capital expenses are those that enhance the value of your property.

Example

James lets out a property. He pays a builder to construct a conservatory. This cost is not deductible against rental income because it is a capital improvement. It enhances the value of the property.

 

So what happens to these capital costs?

Capital costs will be deducted when the property is eventually sold and any capital gains tax is being calculated.

 

But I heard I could claim capital allowances?

Yes, it is possible - in fact many landlords overlook them. Note firstly though that you cannot claim allowances for furnishings or other items used by the tenant in a residential dwelling; these are subject to their own rules. If, however, you buy plant or machinery wholly and exclusively for your letting business, you can deduct a percentage of the cost every year. This is known as a capital allowance. Common examples of qualifying expenditure would include lawnmowers, ladders and tools. These items will have a yearly allowance of 18% (current rate) based on the reducing balance, i.e. original cost minus 18% = next year’s reduced balance and so on; however, in most cases you can probably use the annual investment allowance (AIA), which is currently £1 million, to write off the full cost in one go.

You can’t claim AIA on cars, but you could potentially claim allowances on, say, a van used in the business.You can claim for travel you undertake for your rental business using HMRC’s approved mileage rates.

Capital allowances can be claimed for furniture and other plant or machinery in the common parts of a residential building containing more than one dwelling. Only the furnishings in communal areas qualify. For example, alarm systems, escalators and air conditioning. Although the kitchen and lounge are communal areas, the costs related to these areas are not allowed. So in a standard block of flats the communal areas would be the stairs, landing and hallway.

 

Is replacing items with better versions a repair or a capital improvement?

It’s important to think about whether there has been any change to the character of the asset that’s been replaced. If an asset is damaged and then is repaired or replaced, as long it’s replaced with something of a similar standard then the cost will be allowable. But where an item is replaced by an improved item only part of the cost is allowed. That is, where the replacement is “not substantially the same” as the old item, the deduction is limited to the amount that would have been incurred on an item that was the same or substantially the same.

As modern technology becomes standard, old items become obsolete and are no longer used. An example of this is the replacement of a single glazed window with a double glazed window. HMRC appreciates the advancement in technology so it allows landlords to deduct costs relating to replacing old items with modern equivalents. As mentioned earlier, any non-deductible costs may be deductible from any gain made from the sale or transfer of the property.

 

What about replacing fixtures and fittings?

When an item is attached to a building it’s treated as part of that building. These are known as fixtures and fittings. When fixtures and fittings are repaired or replaced the cost is deductible. Examples of fixtures and fittings are kitchen units, radiators, boilers and toilets.

Example

David lets a property to a tenant for the whole of the tax year at £15,000 per year. The property is furnished. David incurs the following expenses:

Deductible interest on mortgage	£5,000
Repairs to bathroom units	£450
Extension to house	£15,000
Insurance	£700

 

The building insurance was paid in advance on 1 October. On 1 October in the previous year David paid building insurance of £650.

The rental profit is:

	£	£
Income
Rent receivable		15,000
Less expenses:
Interest on mortgage	-5,000
Repairs to bathroom	-450
Extension to house - CAPITAL	0
Insurance	-700
		-6,150
Taxable profit		8,850

 

I’m letting the property furnished. Can I claim the costs of buying the furniture?

No, the cost of initially kitting out a dwelling with white goods, sofas, beds, etc. cannot be claimed against income. However, from 6 April 2016 a statutory deduction has been available where such items are replaced, and the old item is no longer available to the tenant. This doesn’t apply to furnished holiday lets or lettings to which rent-a-room relief applies.

 

How do I claim a deduction?

Allowable costs (as discussed above) are simply deducted as an expense when working out the rental profit for the relevant tax year.

 

Do I need to apply VAT to the rent?

When you let a property (residential or commercial), it is an exempt supply. So you do not charge VAT. There is a complicated process by which you can make an option to tax commercial rentals, but it is not discussed here.

 

Can I claim back VAT costs if I’m not VAT registered?

No - the fundamental rule of VAT is that you can only reclaim VAT if you charge VAT on your supplies. You can, however, include the VAT element of any allowable costs when working out your taxable rental profits, i.e. if your repairs cost £2,000 plus VAT, you would include £2,400 in your rental accounts as the cost.

RELIEF FOR MORTGAGE INTEREST AND OTHER COSTS OF FINANCING

What are finance costs?

Finance costs include mortgage interest, interest on loans to buy furnishings and costs when taking out mortgages and loans, such as brokers’ fees and set-up fees. The capital repayment part of the mortgage payment is not deductible, as it is not a true cost - you are simply repaying the borrowings.

Major changes took effect from 6 April 2017 and it is essential that you understand these when considering how to finance a purchase, or when looking at refinancing existing borrowings.From 2020/21 onwards, no direct deduction is available for these costs. Instead, a tax reducer operates to give a more restricted relief.

 

How does the reducer work?

The tax reducer is maximum of 20% of the finance costs that would have been deductible under the old rules. It will be given as a bottom line deduction in the overall tax calculation, i.e. it will not form part of the rental income and expenditure, and cannot reduce the tax liability below £nil.

Example

Tony takes out an £80,000 interest-only mortgage to buy a rental property. His monthly repayments are £350. At the end of the tax year, the amount outstanding on the mortgage will still be £80,000 and the annual interest will be £4,200 (12 x £350). A tax reduction of £840 (20% x £4,200) will also be available; however, this can only reduce the overall tax liability to £nil.

Unfortunately, because the way the reducer works it will increase rental profits and (at least on paper) there will be a knock-on effect for tax credit claims and the higher income child benefit charge.

 

What were the rules previously?

The interest part of a mortgage was deductible in full for years up to and including 2016/17. This is true for both repayment and interest only (often referred to as buy-to-let) mortgages, which may be relevant if you need to submit a return. You do need to ensure you don’t claim the capital repayment part of the payments though. You should receive an annual interest statement showing the exact amount of interest from your lender. If you don’t, contact them and request one.

 

How will this affect me?

If you are a higher or additional rate taxpayer, you will be worse off than in previous years because the reducer is restricted to the basic rate (currently 20%), whereas the old deduction method would give you full relief at 40% or 45% accordingly. Basic rate taxpayers will be least affected; however, because of the particular way tax is calculated it could mean that you pay more tax on less actual profit.

So if you are a basic rate taxpayer, you can claim fewer finance costs and as a result your rental profits could increase in comparison to previous years. As you will have a larger rental profit, you could become a higher rate taxpayer, paying some tax at 40% and only receiving a basic rate tax reducer. Similarly, higher rate taxpayers could become additional rate taxpayers.

Also, if the interest element of the mortgage payments had previously resulted in a small net loss, you could start generating profits after the change and pay tax despite making a cash loss.

 

Are there any restrictions on this reducer?

Yes - the basic rate deduction is a maximum of 20% of the disallowed finance costs, but it can be less in the following circumstances:

• when property profits are less than finance costs, the deduction is limited to 20% of the property profits
• when there are property losses brought forward these must be set against property profits before applying any tax reduction, and could reduce the taxable profit to a level which is lower than the finance costs. Here the deduction is limited to 20% of the taxable profits as discussed above
• when total income (excluding any savings or dividend income which are taxed as top-slices) is low, so that some or all of the rental profits fall within the personal allowance, the deduction is restricted to 20% of the profits that are actually taxed.

Example

Geraldine has a director’s salary of £9,000 in the last tax year, as well as rental profits (not accounting for finance costs) of £8,000 and dividend income of £35,000. She pays £8,000 of mortgage interest in relation to her let properties. Assuming the personal allowance is £12,570, the rental profits which will be subject to tax are £4,430. The maximum potential tax reduction is £1,600 (i.e. 20% x £8,000); however, this is restricted to £914 (20% x £4,430).

When there is a restriction, any finance costs which have not been used to calculate the basic rate deduction in one year can be carried forward and added to the finance costs of the following year. In Geraldine’s example, £3,570 has not been utilised and so will carry forward to subsequent years.

At its worst this could mean that you have to pay tax even though no cash profit has actually been made.

 

I’ve made a loss. What can I do with it?

A property business loss arises when your allowable expenses (as calculated in the previous two chapters) exceed your gross rental income. If you have more than one rental property, all the property profits and losses are pooled together, creating an overall profit or loss.

An overall property business loss can only be carried forward and used against future property business profits.

Example

In the most recent tax year, Pam received rental income of £7,500 and has allowable expenses of £9,000 for her property in Oxford, which resulted in a loss of £1,500. She also has a property in Birmingham that had rental income of £8,000 and expenses of £7,500, leaving a profit of £500, which is offset by some of the loss from the Oxford property. In the tax year she has profits of £2,000 and £2,500.

In the previous tax year Pam has an unrelieved overall loss of £1,000. This loss is carried forward to the next tax year and set against the overall profit of £4,500. Therefore, she has taxable property profits of £3,500 in the most recent tax year.

Any property losses are claimed on the UK property pages of your self-assessment tax return.

Ensure you do claim your losses. A common mistake for new landlords to make is not to report the rental business until it starts making a profit. Not only is this contrary to tax law and could result in penalties being charged, it also means that you are missing out on valuable tax relief.