Why is there confusion?
Tax can be opaque at the best of times. But letting property adds a new layer of complexity, not least because the tax rules are completely different from those that apply to selling your own home or renting out a room.
What are the basics?
Rent paid on a property is liable to income tax just like earnings from employment or a pension. However, landlords can claim allowances to offset their letting tax bill.
What can you claim for?
There is a long list of expenses that can be set against rental income. Top of the list is interest on the mortgage used to buy a letting property or properties. But this does not include mortgage capital repayments. Other costs that can be claimed include insurance paid by the landlord and any fees due to a managing agent. Landlords can claim ten% of the annual rent against 'wear and tear' - the cost of replacing furnishings over time. Other permitted expenses include legal and accountancy fees related to the letting.
How onerous is the process?
Landlords must declare their income on a tax return. If the renting income is more than £15,000 a year, they must submit a full return. If less, they may be able to send in a four-page return.
What happens when you sell?
Unlike your main residence, investment properties are not exempt from capital gains tax at 40% on any sale profits. But the bill can be reduced. Everyone has an annual CGT exemption - the first £9,200 of profits in any tax year are free from tax. There are also reductions for those who have owned a property for more than three years. This taper relief can reduce the CGT bill by up to 40%. And there are further reliefs for those who have previously lived in the property. If you are new to property investment you need to be aware of the issues surrounding the taxation of your rental property income. Don't for one minute think you can get away with not declaring the income from that buy-to-let property you bought last year: tax evasion is a serious crime with heavy penalty fines and even jail. It's just not worth it!
It's very likely that in the early stages you won't make a taxable gain (profit) from your letting as your mortgage tax relief, coupled with your other allowable letting expenses, will add up to as much, if not more, than your rental income. However, if you do make a taxable gain you must declare this to HM Revenue & Customers within 6 months of the tax year end (5th April) which means by the 5th of October at the latest.
Also, remember that any tax losses you make can be off-set against any taxable gains you made from other properties and also rolled over to subsequent years. If you own property jointly with your spouse, then your combined tax allowances will also mitigate the amount of any tax payable.
Rental income is taxable under Schedule A. If you want to get the real technical detail on this the HM Customs & Excise Property Income Manual (PIM) is the place to look. You can also get information about tax relief on mortgage payments here RE40.
Allowable expenses can be deducted providing they are incurred "wholly and exclusively" in connection with the letting:
• Letting agent's fees
• Legal fees for lets of a year or less, or for renewing a lease for less than 50 years
• Accountant’s fees
• Buildings and contents insurance
• Interest on property loans
• Maintenance and repairs (but not improvements)
• Utility bills paid by the landlord (like gas, water, electricity)
• Rent, ground rent, service charges
• Council Tax
•Services you pay for, like cleaning or gardening
• Other direct costs of letting the property, like phone calls, stationery, advertising, travelling to and from the property.
• Specific bad debts (rent arrears).
Where the gross annual income from your property letting is under? 15,000 you can simply include the total expenses on your tax return; if it's over £15,000 you will need to provide a breakdown of all the expenses.
Some costs of letting are not allowable as deductions: generally you cannot claim any "capital" costs such as expenses involved in purchasing the property, furnishings for the property and any improvements you make to the property prior to letting it, but you can claim for "repairs".
Sometimes work has a capital element and a repair element combined. In this case it may be necessary to apportion these amounts.
Depending upon the type of letting you make, you can claim a "capital allowance". In the case of UK and overseas-furnished lettings you can claim a 10% (of the net rent) "wear and tear" allowance on furnishings and equipment.
An alternative to the wear and tear allowance is the 'renewals' allowance. This covers the cost of replacement furniture or equipment, even small items like cutlery.
Once you have opted for one of these two, you cannot switch back, so think about it carefully first.
In the case of UK Furnished holiday lettings, you can claim a 'capital allowance' for the cost of each item of furniture and equipment, or you can claim a renewals allowance, as above, but you can't claim wear and tear allowances.
"Capital Gains Tax" (CGT) is a separate tax on all forms of capital gain. It is charged on the tax payers marginal rate of Income Tax - (10%, 20% or 40%). Prior to 1988 you got "indexation relief" for inflation, now replaced by "taper relief" which is less generous. The value of property assets were re-based 31 March 1982, so if you owned the property before that date you need a valuation at that date.
Some useful exemptions are that transactions between spouses are exempt, there's no CGT on death and your principal private residence is exempt. There is also an annual exemption for each individual of ?8,800 (2006/7) so if husband and wife have joint ownership this amounts to an annual exemption of ?17,600
Sometimes capital gains that are not exempt can be deferred, which is called "roll-over-relief". This applies to businesses (trade) only, so holiday lettings, which are deemed to be a business operation, can use this exemption, whereas a buy-to-let operation cannot. Business income is deemed to be "earned income", whereas property letting is deemed to be "investment" (unearned) income by HM Customs and Excise.
Inheritance Tax is a major consideration for most property owners as the value of the average house is now approaching the IHT allowance, and anyone owning more than one property is almost certain to be into IHT on property alone. The IHT allowance is 285,000 (2006/7) and all assets above this are taxed at 40%
There is scope for tax planning with both Capital Gains Tax and Inheritance Tax, so anyone considering building up property assets should consider these aspects very carefully at the outset.
Stamp Duty Land Tax (SDLT) is a tax on the transfer of land, unlike the former version which was Stamp Duty - a tax on documents. The new tax can be charged on any agreement and also applies to some leases. There is quite an onerous system of self-assessment with this tax. Further
Information on Stamp Duty Land Tax
We have tried to spell out the basics of the UK tax system as it applies to property and property investment. In fact the tax system is complex and anyone contemplating investing in property would be well advised to consult a tax specialist. You can also gain a lot from reading some of the specialist tax guides on the market.