Tax is an aspect of residential property investment which is often overlooked. There are many twists and turns to consider at all levels, whether it be for income tax, capital gains tax or inheritance tax, and it is important to get the structure of ownership right and to make sure that all tax relief, allowances and claims are made.
This section summarises some of the main aspects of the principal areas of property tax. There are many detailed aspects to consider at each stage, and it is very important to obtain good professional advice if there are any doubts as to the applicability of any rule. Tax decisions can be influenced by what other income and assets the tax payer has and will not necessarily be the same for every property investor.
All areas of tax require the practice of good record-keeping (this is equally applicable when a property is sold). It is essential that full and accurate records are kept of all income and expenditure, perhaps maintaining a separate bank account for these, so that all of the information is readily available to allow the taxpayer to claim the maximum deductions and pay the minimum amount of tax. Failure to keep adequate records can result in penalties.
1.8.1 Income Tax
If the landlord is a new property investor HM Revenue & Customs (HMRC) should be notified immediately of the new source of income which the landlord is now receiving. The tax is computed through an annual tax return sent to HMRC.
Income tax is payable on profits made from the property-renting business by computing the total of rents receivable less expenses. Tenants’ deposits do not count as income. Typical expenses which can be deducted include:
- repairs and maintenance (though not initial expenditure needed to bring the property up to a letting standard, or improvements)
- ground rents
- service charges
- contents and building insurance
- managing agent’s fees
- legal fees for tenancy agreements
- HMO licence costs
- water rates
- Council Tax
- accountancy fees
- subscription to a landlord association;
- certain motor and travelling expenses
This list is not exhaustive and can vary in individual circumstances.
Mortgage interest is no longer allowable as a deductible expense, meaning the landlord got the benefit at the highest rate of tax they paid. The new scheme, in transition between 2017 and 2020, will add the rent net of allowable expenses to the other income of the landlord and then it will be taxed. There will then be a 20% allowance for mortgage interest. This has two effects. Firstly, landlords who pay tax at higher rates will only get tax deduction at the basic rate. Secondly some people who were not higher rate taxpayers may find they now do pay tax at the higher rate as the rent (before deduction of mortgage interest) will be added to their other income. Landlords should seek specialist advice on tax to ensure the right amount is paid.
On the question of repairs and maintenance, it is important to distinguish between items of repair and items of improvement. Redecorating rooms, changing windows from single to double-glazing, or replacing a defective roof are examples of repairs which will be allowable. The addition of another floor to the building, or a new conservatory would not qualify and tax relief would only be received on the eventual sale of the property, being set against the eventual capital gain.
Where properties are owned in joint names, then the profits can be shared between the joint owners or, in certain circumstances, can be wholly attributable to one or other of the joint owners. Where a husband and wife own a property jointly, the income is automatically assessed equally, even if the actual ownership proportion is not equal, unless they elect otherwise.
For Capital Gains Tax purposes, the proportionate ownership is important, and any capital gain would be shared between the joint owners in their respective proportions giving rise to multiple tax-free allowances.
In certain circumstances, it may be worthwhile for a limited company to be brought into the structure. It is normally sensible for the properties themselves to be held in individual or joint names, but these can be sub-let to a company which then lets the properties to tenants. Professional advice should be sought to look at the best structure for any given landlord to use to own investment properties.
1.8.3 Capital Gains Tax
Capital Gains Tax (CGT) is a tax on the gain or profit made when shares or property are sold, given away or otherwise disposed of. There is a tax-free allowance and some additional reliefs that can reduce a Capital Gains Tax bill.
Capital Gains Tax is one of the most important taxes to consider as property prices will usually rise over the long term. As the amounts at stake are potentially significant, it is important to make sure that all of the available tax relief and allowances are taken advantage of. Many of these offer scope for substantial reductions in the ultimate amount of tax to be paid.
The basic concept is quite simple: the final price received for the property when it is sold (after deducting legal costs and agent’s fees) is compared with what the property cost initially (including any legal fees and Stamp Duty), and the profit or ‘gain’ is calculated on which tax is levied. There are then potential deductions and tax relief available, the most important of which are as follows:
- the cost of any improvements to the property whilst under ownership can be deducted (but not the cost of repairs which has previously been set off against Income Tax)
- if the property has been occupied by the owner as an owner-occupier at any time, then there are two additional very valuable reliefs:
- lettings relief whereby up to a certain amount of any gain per owner can be tax free
- a proportionate principal private residence relief
- if the property was owned at March 1982 its value at that date is substituted for the original cost of the property in calculating the ultimate gain
- set value of any capital gains in a single tax year is tax-free per individual (not per property), tax only being charged on any gain above that value
- if there are two properties which have been used as a residence (e.g. one in London and one in the country), it is worthwhile making a principal private residence election on one of those properties to maximise capital gains relief. This will also reduce the potential CGT payable if one of the properties is let at any time in its ownership.
1.8.4 Inheritance Tax
Where a property is owned at the date of death, the value of that property forms part of the estate and is potentially liable to Inheritance Tax (IHT). If the property is left to a spouse in a will, then no IHT will be payable until the death of the spouse.
There are ways of reducing the Inheritance Tax liability. A tax-efficient will should be drawn up to ensure maximum use of IHT allowances. Wills and trusts are specialist areas where it is important to obtain professional advice. Advice will vary depending on the individual’s circumstances.
1.8.5 Stamp Duty
Stamp Duty Land Tax (SDLT) is payable by the purchaser within 30 days of the purchase, so this should be taken into account when budgeting for a purchase. No Stamp Duty is payable below the prevailing threshold, but above the nil-rate threshold the applicable rate of SDLT will depend upon the price paid. There are reliefs available in ‘disadvantaged areas’ – but these only apply to the lower-value properties in those areas. The list of disadvantaged areas is much longer than one would imagine, so it is always worth checking to see whether relief is available. Go to www.hmrc.gov.uk and search on ‘Postcode Search Tool’ to see if a property could qualify. The value of any fixtures, fittings or furniture included in the purchase can be excluded from the purchase price in calculating the Stamp Duty payable, though the Stamp Duty Office will look at any obvious overloading.
Stamp duty for seconds homes attracts an additional premium of 3% over and above the normal rate. This means most landlords will have to pay this premium, as will home owners buying a second home.
At the time of writing, SDLT is being reviewed and a tax specialist should be consulted.
1.8.6 Value Added Tax
Under normal circumstances, landlords cannot register for Value Added Tax (VAT) in relation to their residential properties, as residential rental income is exempt from VAT. This means that any VAT incurred cannot be reclaimed. However, landlords who are VAT-registered in their own self-employed businesses may be able to claim some VAT incurred.
A special VAT rate of 5% is available on the renovation or alteration of a single household dwelling that has not been lived in for three years or more, so that this is a useful saving over the normal 20% rate.
More information on tax can be obtained from a local tax office or visit HM Revenue & Customs website at www.hmrc.gov.uk. Copies of leaflets on taxation of rents and other tax matters can be downloaded from HMRC’s website, or can be requested by phoning the Order Line on 08459 000 404.