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!
Income Tax
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 equation
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:
| Expense | Description | |
| 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! | |
| Insurances |
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 - Indexation Allowance = 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.
The Indexation Allowance is a multiplier on the purchase price that takes into account price inflation. It helps reduce the Capital Gain and hence reduces your tax bill. Indexation Allowances can be calculated from the Inland Revenue official Retail Price Indexes (RPI) available from the Inland Revenue. Visit www.inlandrevenue.gov.uk
How to reduce your Capital Gain
Since the property you have bought is deemed to be a business asset then any capital gains that you do achieve from the sale of your property can be offset against either one of these three reliefs:
- Rollover relief – If you fully invest the whole proceeds from the sale in another business asset i.e. another investment property within two years or one-year prior of the date of the disposal then the capital gain does not attract capital gains tax.
- Retirement relief – If you are over the age of 50 and retiring, or retiring due to ill health at any age, then the capital gain is exempt of tax. This is subject to certain limits.
- Enterprise Investment Scheme shares or Venture Capital Trusts shares – If you invest the proceeds of the sale of the property in EIS shares or VCT shares then there is no capital gains tax to pay. This is a government incentive for investors to invest in company start-ups to encourage new business.
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