Property tax: Finding ways to escape the pitfalls

As the impact of lower interest rates begins to filter through, many landlords will be finding that they have an unexpected rental profit which will become an even more unexpected tax liability next January. What should landlords be doing about it and with the new tax year well underway, are they already too late to take avoiding action?

Every cloud has a silver lining and the gloom hanging over the depressed property market and the lack of availability of new funds is a cumulonimbus of epic proportions. There are however many thousands of landlords with long term funding in place, many of whom are currently benefitting from variable rate loans on which annual interest charges have plummeted since last autumn.

These landlords, most of whom have expected their rental income to just about cover their annual outgoings, have suddenly found themselves in the rather fortunate position of making a healthy surplus. In some exceptional cases where landlords took out tracker loans below base rate, they are finding that their interest charge has been virtually eliminated altogether.

This is clearly very encouraging news but it obviously won’t last… however while it does, there will be plenty of pressure to spend this fast growing pot of cash. The first and arguably most important claim on the profit will be from the chancellor who will want to have his rather large slice of the windfall. In fact to be precise he will want two rather large slices that could add up to a whacking 60 percent of last years profit in one painful payment on January 31, 2010.

It is a strange by-product of the current self assessment tax system that following the first period of profitability there is a double whammy of tax, first a payment in respect of the whole of the profitable year just concluded and second, a payment on account of the next (current) tax year, based on the profits of the previous year.

Although the payment on account for the following year is split into two payments, the first of these falls on the same date as the payment of tax for the prior year creating an horrendous outlay for the unprepared taxpayer. This amounts to 40 percent tax in last year’s income and half again as a payment on account.

So what steps can be taken to minimise the inevitable pain now that we are already well into the 2009/10 tax year?

Use previous year’s losses
Many landlords don’t make surplus rental income – and more often than not their properties make taxable losses every year. They rely on the capital growth for their return. There is however a natural tendency to be lazy and not to register these losses each year with HMRC, after all what’s the point if there is no tax to pay! In addition there is a reluctance to claim all the legitimate expenses (of which more later) so that the extent of the losses are not maximised.

So the first step is to make sure that brought forward tax losses have been optimised and formally recognised so that they are available to offset the unplanned profitable years now arising. Rental business losses can only be used against rental business profits in future years and are not available against the taxpayers other income. They are however available to carry forward indefinitely until relief can be given.

Claim legitimate expenses incurred
Many of the big ticket expenses are obvious, mortgage interest and letting agents fees for example, but many costs are overlooked. In addition some expenses are disregarded as they are thought to be of a capital nature and thus add to the value of the property rather than being offset against the rental income.

Technically all expenses must be ‘wholly and exclusively’ for the purpose of the rental business if they are to be deductible against rental income however HMRC does allow the apportionment of some expenses where there is a duality of purpose.

Repairs are defined as the restoration of an asset by replacing parts of the whole asset. There won’t be a repair however if a significant improvement of the asset beyond its original condition results – that will be capital expenditure as will any improvements to the property.

This is however a grey area giving scope for argument and interpretation. HMRC generally accept that a like for like replacement using up to date materials is not a capital improvement but a revenue repair.

Other smaller items of allowable expenditure may include advertisements, electrical and gas safety certification, professional fees, subscriptions to trade journals or professional bodies and travel expenses to and from the property.

Provisions for repairs to premises
A taxpayer can also deduct expenditure on repairs where the liability to pay for the work is incurred during the tax year but payment has not been made by April 5. However a provision for repairs to premises that they propose to incur in the future is not deductible. For example, they can’t claim a deduction for repair work they think will need doing next year but which they have not yet incurred any liability to pay.

Wear and tear
Residential properties that are let complete with fixtures and fittings are eligible for a wear and tear allowance – effectively an allowance for the depreciation of the furniture and fittings – calculated at 10 percent of the rental income.

In most cases this will be the most effective claim to make however, under extra-statutory concession B47 the taxpayer can claim a ‘renewals allowance’ as an alternative under which the net cost of replacing a particular item of furniture is allowed as a revenue deduction.

The rules do not allow the taxpayer to chop and change the claim each year however if there was a large amount of additional expenditure during the year (perhaps because of the surplus cash being generated) a claim for a renewals allowance may be very effective in reducing taxable profits.

Jointly owned property
If surplus profits continue to be worrying you then perhaps consideration should be given to splitting the rental income between yourself and a lower earning spouse. The use of a spouse’s annual allowance or basic rate tax band can have a significant impact in reducing the overall tax liability.

Where property is in joint names a declaration will need to be made to HMRC within 60 days and proper legal advice should be sought as it will affect your legal entitlement to a share of the asset.

…and finally
Maybe the best option for taxpayers is to save the cash and pay the tax as one day soon the tide will turn and those floating interest rates will be rising on the incoming flow.

The cash will be needed to stay afloat.

Perhaps now is the right time to give serious thought to locking into some sensible fixed rate money – but that will have to be the subject of an entirely different article.

For more information
Paul Windsor is a partner at specialist UK real estate tax advisor WSM Property
Website: wsm.co.uk