This article appeared in the Yorkshire Post on Saturday 26th July 2008.

Know the rules on holiday lets or you could be paying the price

Richard Whitelock Tax Specialist

Amid the forecasts of impending recession and spiralling inflation, the economic downturn continues to put pressure on the property market, including the buy-to-let sector.

Following the recent upheaval of the Capital Gains Tax rules from 6 April, it is worth reminding ourselves of the pertinent tax issues for those letting, or perhaps considering letting, holiday accommodation.

It is important firstly to understand that only let properties that meet all four of the following tests will qualify as “Furnished Holiday Lettings” (FHLs):

• The property must be situated in the UK
• The property must be available for holiday letting to the public on a “commercial basis” for at least 140 days in a year
• The property must be actually let for at least 70 days in a year
• Any periods of “longer-term occupation” (more than 31 consecutive days by the same person) cannot exceed 155 days during any year.

The final test distinguishes between normal furnished/unfurnished lettings (where tenants typically occupy the property on six or twelve month leases) and holiday lettings (where the property is let for a week or so at a time to different tenants). It also ensures that properties let to students during term time do not qualify. These tests are applied for each tax year that the property is let and there are special rules for the first and last twelve months of letting.

It is worth noting that the “commerciality test” has been an issue on which the Revenue has successfully challenged that FHL treatment should not apply (an example being if there are continued rental losses each year due to significant borrowings against the property). Also, if there is any personal use of the property (by either the owners, or perhaps allowing friends or relatives to stay rent-free or below market rent) the deductibility of some expenses may need to be restricted.

For all types of property letting, Income Tax is due at 20% or 40% (depending on the owner’s marginal tax rate) on any rental profits made each tax year. Profits are calculated by deducting any allowable expenses from the rental income received each tax year.

The difference between FHLs and other lettings comes if there is a rental loss during the tax year (i.e. where the allowable expenses exceed the rents received). For FHLs a rental loss can be offset against other taxable income of either the tax year of loss or the year before, so tax relief on the loss is often immediate.

For non-FHLs, the loss can usually only be carried forward and offset against any rental profits made in future tax years, meaning tax relief is delayed and in some cases doesn’t materialise at all.

Capital Gains Tax (CGT) is due on any gain realised on eventual sale of the property. Before 6 April, the gain calculation included a deduction for “taper relief“ (based on how long the property was owned for) and the rate of tax was determined by the individual’s marginal rate. Under these old rules, if a FHL had been owned for at least two years, the gain would qualify for the maximum 75% taper relief, meaning that a higher rate taxpayer would pay an effective tax rate of 10% and a basic rate taxpayer could pay an effective tax rate of just 5%.

However, the Chancellor introduced new rules on 6 April that abolished taper relief, indexation allowance and the use of marginal tax rates. Under the new regime, any gain is now taxable at a flat rate of 18%.

The 18% flat rate was welcome news for higher rate taxpayers selling let property that did not qualify as a FHL - under the old rules they would have paid an effective tax rate of 24%. However, for those selling FHLs this change represented a large tax increase from 10% to 18%.

In response to the criticism that ensued from businesses owners, the Chancellor introduced “Entrepreneurs’ Relief”, which effectively reinstated the 10% rate for those selling qualifying businesses. The good news for owners of qualifying FHLs is that they too qualify for this relief, so provided the necessary tests are met during the required one year period before sale, any gain realised will be taxed at 10%.

Don’t forget that each taxpayer has a CGT annual exemption each tax year, which is currently £9,600. As a simple example, if a gain of £50,000 was made on the sale of a FHL, the first £9,600 would be tax-free and the balance of £40,400 would be taxed at 10%, resulting in a tax bill of just £4,040.

Finally, it is also worth highlighting that FHLs qualify for many of the CGT reliefs that apply to businesses, along with Inheritance Tax “Business Property Relief” in many instances.

If you own, or are considering owning, property of any kind, it is recommended that you seek professional advice.