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Residential Property Letting

Richard Whitelock

With the Pre Budget Report still fresh in our consciousness, it is clear that there is a big gap in the Treasury’s finances.  Whilst the coming hike in National Insurance will not affect income from lettings, it is hard to see where the tax grab will end, if spending is not to be reined in.  So, it is even more important to ensure that, if you are managing to keep on top of your property finances, you obtain all the deductions you are entitled to.

It is usual for the investor to be intending to acquire residential property but there is a growing interest in commercial property letting.  In this article, I shall concentrate on rules for residential property acquired by individuals.

When buying the property, it will probably be necessary to borrow.  In the current climate, with lending restricted, there may be little new activity but historically lenders have lent up to 85% of the cost of the property.  Now, this proportion will be less, and any shortfall (together with any ‘fit out’ costs) will have to be found from elsewhere.  Whatever the source, take care with interest costs and whether the rent will cover the borrowing, rates and insurance, as well as leaving something to cover repairs or unexpected bills.  Interest rates are currently low for some (but not all) borrowers.  However, rates will begin to creep up again.

In tax terms, the original purchase cost (including stamp duty land tax (SDLT)) will not be deductible against the rental income but will be stored up for the time when the property is sold.  These costs will then feature in the capital gains tax (CGT) calculation.  Some initial costs (e.g. bank fees for arranging the lending) will be deductible against income but the general theme is that annual costs only can be matched against annual receipts.

Examples of receipts and costs and their tax treatment are as follows (the key being to keep full records, including invoices):

Capital receipts and costs

• Proceeds of sale, less selling costs.
• The total purchase cost, including SDLT, search costs and legal fees.
• The cost of improvements (other than repairs).
• Refurbishing costs may be capital, if the property isn’t in a fit state to let out when you buy it.

Income (revenue) receipts and costs

• Rent and associated charges.
• Fees paid to agents to manage the property.
• Tenant advertising costs.
• Interest costs and bank fees connected with loans.
• Buildings (and, if applicable, landlord’s contents) insurance.
• Water & sewerage charges.
• Council tax (exempt if occupied by students).
• Repairs (see below).
• Sundry costs (including stationery, mileage – but must be ‘wholly and exclusively for the purpose of the lettings business’).
• Accountancy costs, if applicable.

There may be some doubt whether a repair is deductible, where it is a replacement asset or improves the original.  For example, the windows may be single paned and are replaced with double-glazing.  The general rule is that if the replacement is still a standard fitting, and it is the current standard item that has improved with the passage of time and the improvement of technology, then it is a repair.  If it is a new asset, however small (e.g. an extractor fan), it is not a repair.

Another general rule is whether the replacement is of a part or is the whole.  Old tax cases on this point centred on the replacement of chimneys.  A small chimney on a roof was a repair; a stand-alone 180-foot chimney was not.  You can see the line of thinking here, so a new fridge is not a repair.

In fact, for a furnished property there is an unusual method of getting a deduction for furniture and fittings.  There is the choice of either nothing for the initial purchase then a deduction for the full cost of the replacement (‘the renewals basis’), or an annual reduction of the rent by 10% (the ‘wear and tear allowance’).

Profits from a rental business these days are calculated in the same manner as if it were a trade, with income and expenses matched to the current period, not necessarily when actually received or paid.  Losses can only be carried forward against future rental profits, not set against other income (this is different for companies, where rental losses can be set against all profits).

Furnished holiday lets will lose their special status from April 2010.  They will no longer constitute a trade but will be the same as any other property rental business.  This means that the current advantages in relation to e.g. loss relief and capital gains will be lost permanently.

When it comes to sell, the tax treatment will be calculated under the CGT regime.  The difference between the sale proceeds and the sum of all the capital costs will be taxed as a gain, at an 18% flat rate.  There is speculation about how long this rate will continue, now that income tax is to go to a maximum 50%.  There is usually scope for planning to mitigate this, if considered early enough, particularly by efficient use of the individual’s CGT annual exemption.  Companies owning property may have more scope to mitigate the tax on sales.

Finally, property ownership is often seen as ‘pension planning’.  However, its success breeds another problem, a growing IHT burden.  Again, early attention is the best way to address this.