We all hate paying tax – but we have to. This chapter deals with the key figures when calculating your tax and how to legally minimise your tax bill. Let’s identify the types of tax you will be subject to if you invest in property.
Types of tax
There are two types of tax that property is subject to:
1. Income Tax – This tax is applied to the profit generated from the renting out of the property. It has to be paid every year in half-yearly instalments on 31st January and 31st July. Taxable profit is deemed to be:
Taxable rental income – allowable expenditure = taxable profit
Taxable rental income and more importantly, allowable expenditure will be defined in detail so you can easily calculate and reduce your taxable profit by claiming all allowable expenditure.
- Capital Gains Tax – This tax is only applied once the property has been sold. It is essentially the tax applied to the profit you have made from selling the property.
Detailed below are certain reliefs that you can claim to minimise your capital gains tax bill to zero!
You will only ever pay tax on your taxable profits, that is to say you have to make money before you pay tax. Income has to exceed expenditure – if you have not achieved this then you should not even be interested in this chapter. If you are in the position where income does exceed expenditure then read on.
The simple equation for calculating your income tax bill is:
Taxable rental income – allowable expenditure = taxable profit
So in order for your taxable profit to be the lowest possible then the ‘taxable rental income’ must be minimised and the ‘allowable expenditure’ must be maximised.
Minimising ‘taxable rental income’
This is very difficult to do. Taxable rental income is deemed to be any rental income earned in the period, the period usually being the tax year 6th April XX to 5th April XY. “Earned” means not only what the tenant has paid but also what the tenant owes even if it has not been paid yet. Basically there are no tricks in reducing taxable rental income, apart from one – if a tenant is 14 days in arrears then you can consider that debt as a bad debt and not include this as taxable rental income. The reason you can do this is because you can file for eviction of your tenant if they fall 14 days behind. If the tenant does end up paying then you can include the income in the following accounting period. 14 days outstanding rent is in real terms not that much and you’ll have to pay tax on the income in the following year anyway. The only real benefit is cashflow. This is because you save slightly on your tax bill and defer payment on this omitted rental income until your next tax return the following year.
Maximising ‘allowable expenditure’
This is easier to do than minimising rental income. This is because the Inland Revenue grants certain allowances based on certain definitions as well as allowable expenditure. This means expenditure and allowances can be deducted from the taxable rental income to derive the taxable profit. The two pure definitions that you need to remember for allowable expenditure and taxable allowances, as stated by the Inland Revenue, are:
- ‘Any costs you incur for the sole purposes of earning business profits’
- ‘Capital allowances on the cost of buying a capital asset, or a wear and tear allowance for furnished lettings’
‘Any costs you incur for the sole purposes of earning business profits’
Any expense you incur ‘wholly, necessarily and exclusively’ for the business is fully deductible from your rental income. Any personal expenditure that you make that relates to the business is partly tax deductible from your income. To make sure you include all expenses that are allowable against your rental income refer to this checklist of expenses for inclusion in your tax return:
|Fully tax deductible||Repairs & maintenance||All repairs and maintenance costs are fully tax deductible. Where the property has been altered extensively so as to deem the property being reconstructed, the property is then considered to be modified rather than repaired, hence no amount of the expense is allowed. The only amount allowed would be the estimated cost of maintenance or repair made unnecessary by the modification. Examples of repairs and maintenance expenditure that are fully tax deductible are:|
· Painting and decoration
· Camp treatment
· Roof repairs
· Repairs to goods supplied with the property i.e. washing machine
|Finance charges||Any interest you pay on a loan that you took out to acquire a property is fully tax deductible. It is only the interest and not the capital repayment part that is tax deductible. If any of the finance raised (the loan) is used for personal use, such as a holiday, then the interest paid on the amount paid for the holiday is not tax deductible.|
The typical interest payments that are allowed are:
· Interest on the mortgage taken out to get the property
· Interest on any secured or unsecured loans taken out to get the property
Arrangement fees charged by a lender are also tax deductible.
Interest paid on the car you use to run the property business is partly tax deductible – see below.
|Legal & professional fees||Allowable expenditures are:|
Disallowable expenditure is:
These expenses are added to the purchase price. When it comes to calculating the capital gain when you sell the property:
Gain = selling price-purchase price
This results in the purchase price being higher than the actual price paid due to the addition of initial professional fees. So the taxable gain is lower. These fees are subject to full indexation, as is the purchase price, to allow for price inflation – see Capital Gains section below. So you do get some tax relief but only further down the line, when you sell the property.
|Council Tax, electricity, water & gas||If you are renting out all the rooms then all the usual running costs involved with a property are fully tax deductible. This assumes that none of the tenants make a contribution to the bills. If you let out your property inclusive of all the bills then you can fully charge all the bills you include with the rent. If you let out your property exclusive of all bills (which is the usual way) then you cannot claim. Remember, you can only claim the expense if you actually paid it!|
are fully tax deductible. Life assurance premiums are not as this is personal expenditure. Car insurance is, but only partly – see below.
|Advertising||Any advertising costs in connection with finding a tenant or selling your property are fully tax deductible. This includes:|
|Ground rent||This is the rent you pay if you own a leasehold flat, typically a nominal amount of £50 per annum.|
|Service charges||Service charges are incurred if you own a leasehold flat. If you pay these charges then they are fully tax deductible.|
|Letting agent fees||Any fee that is charged by a letting agent is fully tax deductible, apart from any fees charged for leases created for longer than a year. If a fee is charged for creating a 5-year lease then only one fifth of the fee can be charged for each year.|
|Stationery||Any stationery costs incurred in connection with running your property business are fully tax deductible. This will include items such as:|
|Partly tax deductible||Motor expenses||Motor costs are allowable but only when your car is used in connection with the property business. It is up to you to decide how much time you think you spend using your car for private use and business use. It has to be reasonable. Once you have decided on the split of personal to business, say 70% personal 30% business, then you can charge the business percentage against your taxable rental income, in this case 30%. Typical motor expenses are:|
A fraction of the purchase price of the car can also be taken into account as an allowance – see below.
I charge 80% of my motor expenses to the business. This is because I have 43 properties to maintain around the country and I spend 80% of my driving time on business engagements.
|Telephone calls||Again this is like motor expenses. If you spend 30% of your time on the phone in connection with your business then charge 30% of:|
If there are obvious large private calls (say in excess of £5) then exclude these from the total call expense when calculating the 30% charge.
If you have a fax line then charge 100% of fax expenses as it is difficult to convince the Inland Revenue that you own a fax machine for personal use!
Again this is not an exhaustive list. To make sure you legally maximise your allowable taxable expenditure you have to remember the following two principles:
- Include expenditure if it is ‘wholly, necessarily and exclusively’ needed for the business. If it is, include it. If it is not, exclude it or partly include it.
- Include a proportional amount of expenditure that is split between business and personal such as motor expenses and telephone calls.
2.‘Capital allowances on the cost of buying a capital asset, or a wear and tear allowance for furnished lettings’
This basically means that you can either charge:
- 25 per cent of the cost of any asset used to furnish the property, or
- 10 per cent of the rent
as a tax-deductible expense. You cannot do both. I would always recommend doing the latter, charging 10 per cent of the rent, because once you opt to do one or the other, you cannot change for the duration of your business. The reason I recommend 10 per cent of the rent is because 10 per cent of the rent is likely to be greater than 25 per cent of the cost of the asset. If this is not the case now it will probably be the case in the future. It is better to suffer the lower deductible expense now for the benefit in the future.
You can still claim capital allowances for any asset that you use in the business, such as motor vehicles, but it will be restricted to the business element only. So in the example above of the motor vehicle with 30 per cent business use, a car used in the business costing £5,000 would attract the following relief:
30 per cent x 25 per cent x £5,000 = £375.
You can never charge the cost of an item that you intend to use for longer than one year against your rental income. Anything purchased for the use of longer than one year is deemed to be an asset and only 25 per cent of the cost can be charged each year.
Capital Gains Tax
This tax only arises when you sell the property. The capital gain is worked out as:
Sale price - purchase price = Capital Gain
The sale price is deemed to be the price achieved after deducting estate agent costs, solicitors’ fees and any other expenses that were incurred wholly, necessarily and exclusively in the sale of the property.
The purchase price is the cost of the property plus all survey and legal costs.
How to reduce your Capital Gain
The way to reduce your capital gain is to understand the capital gain calculation. If you dispose of a property the following calculation will be made to work out your capital gain:
The sales price and the purchase price are fixed. You cannot change what you sold the property for or what you paid for it.
To reduce your capital gain you have to maximise the other allowable costs. Lets look at the other allowable costs and what you can include. This part is paraphrased from the Inland Revenue themselves:
|Allowable costs||What you can include|
|(a)||Incidental costs of purchase|
|(b)||Home improvements||These are costs which|
You may not claim the cost of normal maintenance and repairs.
|(c)||Costs of establishing or defending title|
So in a nutshell you can include:
- Solicitor’s costs
- Accountancy fees
- Mortgage broker fees
- Redemption penalties on cleared mortgages
- Stamp duty
- Estate agent fees
- Valuations needed to calculate your gain
- Any improvements that still remain in the property
- Legal costs in defending your title to the property
So the first part of reducing your capital gain is to include ALL costs involved with the purchase, ownership period and sale of the property that fall within the definitions stated by the Inland Revenue. But it doesn’t stop here! You can further relief on the gain. Read on.
You can reduce your calculated gain by up to 40%. Look at this table:
|Number of whole years the property has been owned||Gain remaining chargeable|
|Less than 1||100|
|10 or more||60|
The longer you have owned the property the less gain you have to pay. So in reference to the table above after 3 complete years of ownership you start to attract taper relief. After 10 years or more you attract the maximum amount of relief where only 60% of the gain is chargeable or in other words a 40% discount on the gain chargeable.
Please note it has to be complete years. So another way to reduce your capital gain is, if possible, stall your purchase to capture another year. Look at this example:
Harry has found a buyer for his investment property that he has owned for 5 years 11 months. The capital gain on the sale is £100,000. If he sells straight away then from looking at the table 85% of the gain is chargeable, as he is deemed to of owned the asset for 5 complete years, equating to £85,000. However if he stalls the sale 1 month later then he is deemed to of owned the asset for 6 complete years so looking at the table only 80% of the gain is chargeable equating to £80,000. This method only works for assets being sold that have owned 2 to 9 years. Otherwise it makes no difference.
You can still reduce your gain further. Everybody gets a capital gains tax allowance of £7,900 per tax year rising year on year with inflation. So if you have a gain of £10,000 then it is reduced by £7,900 to £2,100.
If you are selling a couple of properties then if you can straddle the sales either side of the 5th of April year end date of the tax year. This way you can apply your capital gains allowance for the tax year prior to 5th of April on one of the properties and your capital gains allowance for the tax year after the 5th of April for the other property. This way you can make full use of your yearly allowances.
There is one final trick – Principal Place of Residence.
Principal Place of Residence (PPR)
Your own personal residence is not liable for capital gains tax so any gain you make is all yours. If part of your strategy is to let out your home and move in to another home and you sell it within 3 years of leaving your home then there is no tax to pay! If you sell after the 3 years then you still get relief for 3 years. Lets look at this example:
Roger lives in a house that has been his personal place of residence for 8 years, when he bought it, but decides to move out and rent it out. If he sells 2 years after he rented in out there is no tax to pay. If he sells it 5 years later then only:
(5-3)/13 of the gain is chargeable.
The equation being:
(Amount of years rented – 3 years)/Period of ownership.
SIPP & FURBS
You may have heard of these terms fly about in connection with properties and pensions. Let me explain their relevance to this subject.
This stands for Self Invested Personal Pension. The reason why it is mentioned is that you can buy commercial property within this pension and enjoy all the tax breaks a normal pension has. The reason why a SIPP is not applicable in this situation is because we are investing in residential property. Residential property is not allowed under the SIPP scheme.
Commercial property is not as attractive as residential property. The reasons being:
- The yields are lower
- Borrowing is restricted to 70% loan to value
- Business risk is doubled – your are reliant on your tenant’s business to trade well out of your property as well as the normal risks associated with owning the commercial property itself
This is my own personal opinion. You may think that commercial property is for you. If you do get in to this game I would seriously consider investing in commercial property under this umbrella of a SIPP as the shelter to tax is quite significant.
This stands for a Funded Unapproved Retirement Benefit Scheme. Its main beneficiaries are the higher rate tax payers only. So if you’re not a higher rate tax payer and don’t expect to be one then ignore this bit.
If you buy a residential property under this umbrella then:
- Profits from the scheme are taxed at 22% rather than 40% if you are a higher rate tax payer.
- Capital gains tax is 34% in comparison to 40%. A FURBS also attracts the normal taper relief explained above.
- You can pass a FURBS down to your family. There is no Inheritance tax to pay when passed on after death as opposed to being subject to the normal inheritance tax limits (currently £259,000). A traditional pension fund is not passable down.
- There is no limit on the contributions to a FURBS but you do not get any tax relief on your contributions.
- The whole of the fund can be withdrawn tax free compared to a traditional pension fund being restricted to 25%.
- Retirement can be even after the age of 75. Traditional pension funds are restricted to age 75.
The two key things you need to consider on deciding on whether to invest in property using a FURBS is:
- You can only access the money at retirement. If you want to retire prior to normal retirement age then its not possible under this scheme. FURBS restrict your freedom. Once you invest your money in a FURBS you can’t get at it till retirement.
- There are administrational costs involved. You have to use an accountant and the accounting for such a scheme has to be spot on.
Personally I like the freedom that I have. Maybe when I’m over 45 and FURBS are still about then I’ll consider one. I think if you’re target earning is more than £50,000 p.a. profit from property, you don’t require any of this £50,000+ p.a. to live on today and you’re aged over 45 then a FURBS may be for you. Seek professional advice.