BASIS OF UK TAXATION OF INCOME from property
This overview relates to a residential letting activity, which is applicable to most individual landlords. Special rules apply to the RENT A ROOM scheme and to HOLIDAY LETS. Hotels and Guest Houses are also excluded from these general rules.
WHEN RECEIVING RENTAL INCOME, WHAT GETS TAXED?
The profit made on property income is taxable. The profit is calculated as rents less allowable expenses. The default basis for calculating rental income is the cash basis where the income taxable is cash received less cash paid. The earnings or accruals basis remains an available option.
Finance costs including loan and mortgage interest are not allowable in calculating profits of an individual’s lettings business but they may be used to reduce the tax liability at 20% subject to some restrictions. See Finance Cost Relief.
All property income is treated as arising from a single “property business”. With the exception of furnished holiday lettings, the income is treated as unearned income, i.e.: it does not count as income for the purposes of calculating pension contributions, and no National Insurance falls to be paid on it.
WHAT DOES THE LAW SAY?
The taxation treatment of income from property is governed largely by ITTOIA 2005 s272. The main rule regarding allowable expenses is that they must be wholly and exclusively for the purposes of the business. Any element of private use will disqualify a claim for the expense. However the HMRC Manual at BIM 37600 instructs inspectors to adopt a realistic interpretation that is generally helpful.
HOW ARE THE LETTING BUSINESS ACCOUNTS PREPARED?
Accounts are therefore prepared on the normal (accrual) basis for businesses excluding any items of expenditure where there is a duality of purpose.
Rents less allowable expenses are taxable as part of the taxpayer’s total UK income. The main rule for allowable expenses is that they must be wholly and exclusively incurred in the course of the letting business though some relaxation of this rule may be available in specific circumstances. It is important to differentiate initial and capital costs from running costs. Capital costs and set-up costs, which are capitalised, are usually relieved for tax purposes against the calculation of the gain on sale of the investment property. The cost of improvements is normally treated as increasing the base cost of the investment.
HOW IS THE PROFIT SPLIT?
Where a property is jointly owned, the default position is that the profit is divided equally between the joint owners. Where the joint owners are husband and wife, the profit MUST be split equally unless it can be shown that actual ownership is in a different proportion. Other joint owners have some freedom in how profits are split. If a property is owned by two or more people as tenants in common, the split of profits normally follows the proportions in which the property is owned.
HOW ARE “LOSSES” TREATED?
Special rules apply to the treatment of losses. While profits are added to a taxpayer’s income and taxed at the taxpayer's highest rates, losses generally may not be set-off against income from other sources, except for losses created in a property business by Capital Allowances. Capital Allowances are not available in respect of residential property. Losses may be carried forward to offset future profits of the same property business.