Lindsey Wicks examines the tax treatment for landlords of security deposits.
The tax treatment of security deposits received by landlords has been thrown into the spotlight by the consultation on the cash basis becoming the default method of taxation for eligible unincorporated property businesses, which was expected to be introduced from 6 April 2017. This article considers the tax treatment of security deposits under both the cash basis and the current generally accepted accounting practice rules.
It is normal practice for landlords to request a security deposit from tenants when letting residential property, to cover costs that might arise at the end of a tenancy. These costs might include unpaid rent, unrepaired damage caused by a tenant, excess cleaning, replacement of locks and keys or rubbish removal.
Many of these deposits are required by law to be covered by a form of government-backed tenancy deposit scheme. There are separate rules for England and Wales, Scotland and Northern Ireland that have come into force at different times. Deposits in respect of tenancies within the remit of the relevant rules will need to be registered with a government approved tenancy deposit scheme.
In England, Wales and Northern Ireland, the schemes can be either custodial or insured. In Scotland, all schemes are custodial. A custodial scheme means that the deposits are paid over to and are held by the scheme, and an insured scheme means that the deposit is retained by the landlord or letting agent and an insurance fee is paid to the scheme to protect the deposit.
Accounting for custodial schemes
At the start of the tenancy, deposits must be paid over to the selected tenancy deposit scheme within strict time limits. There is a chance that the deposit will still be held by the landlord at the balance sheet date. If this were the case, it would be a current liability in their balance sheet owed to the tenancy deposit scheme.
At the end of the tenancy, if the tenant is to be repaid their deposit in full, the tenancy deposit scheme would pay it directly to the tenant, and there would be no accounting transactions for the landlord.
However, if it is established that the landlord is entitled to some or all of the deposit because of damage or cleaning costs, this would be accounted for as income of the landlord and would be taxable. The costs associated with repairs or cleaning would be tax deductible.
Accounting for insured schemes
The landlord would show the deposit as a current liability for the duration of the tenancy, as it is potentially refundable to the tenant.
If it is established at the end of the tenancy that the landlord is entitled to some or all of the deposit, there would be an accounting entry to recognise some or all of the deposit as income, with any balance being returned to the tenant.
Example – What a mess!
Alice let a property to a tenant in January 2015, and took a security deposit of £1,125. Alice used an insured tenancy deposit scheme, which meant that Alice kept the security deposit and paid an insurance fee.
The tenant vacated the property in March 2017, leaving some of their own furniture and possessions in the property. In addition, the tenant did not have the carpets cleaned in accordance with the tenancy agreement.
It was agreed that Alice was entitled to retain £500 of the deposit and that £725 would be returned to the tenant. Alice spent £210 on cleaning and £305 on rubbish clearance.
Upon receipt of the security deposit, Alice’s accounting entries would have been:
DR Bank account £1,125
CR Tenants’ deposits (current liability) £1,125
At the end of the tenancy, the accounting entries in respect of the deposit would have been:
DR Tenants’ deposits £1,125
CR Income £500
CR Bank account £725
Even though the income from the part retention of the deposit is taxable, the actual costs of cleaning of £210 and the rubbish clearance of £305 would be tax deductible.
The cash basis
The consultation proposals
Given that, under GAAP, any income from a security deposit is only recognised when the landlord incurs costs at the end of a tenancy, HMRC acknowledged in its consultation document ‘Simplified cash basis for unincorporated property businesses‘ issued on 15 August 2016 that a true cash basis could lead to this changing.
The consultation document suggested that for a custodial tenancy deposit scheme, the landlord would show the receipt of the deposit from a tenant as income, but that the payment of the deposit on to the tenancy deposit scheme would be an expense.
However, where the landlord uses an insured tenancy deposit scheme and retains the deposit, it was suggested that the landlord would recognise income upfront on receipt of the deposit, but would not recognise the expense until the end of the tenancy, either through the return of the deposit or actual expenditure related to repairs or cleaning. This could be some years later.
HMRC was concerned that continuing the existing practice of recognising a deposit as income for tax purposes at the end of a tenancy would create complexity in the cash basis rules. On the other hand, it recognised that the difference in the cash basis treatment of custodial and insured schemes could skew commercial decisions.
The consultation outcome
An overwhelming 97% of respondents to the consultation said that it would be inequitable to treat deposits as a cash basis receipt.
Therefore, the consultation outcome published by HMRC on 31 January 2017 confirmed that, in line with existing law and practice, there would be no expectation that refundable security deposits would be a cash basis receipt. Instead, security deposits will continue to be recognised as income only when the landlord’s legal entitlement to retain some or all of the deposit has been established.
The draft legislation
The clause and Schedule in Finance (No 2) Bill 2017 released on 20 March 2017 that related to the cash basis were dropped from the Bill on 25 April 2017 as part of the pre-election wash up process. However, it can be expected that they will be resurrected in a post-election Finance Bill.
This is what the draft legislation had to say about calculating profits of a property business on the cash basis:
‘271D calculation of profits on the cash basis
- In this Part, references to calculating the profits of a property business on the cash basis are to calculate the profits in accordance with subsections (2) and (3).
- In calculating the profits, receipts of the business are brought into account at the time they are received, and expenses of the business are brought into account at the time they are paid.
- Subsection (2) is subject to any adjustment required or authorised by law in calculating profits for income tax purposes. …’
Given the above wording, I was expecting that there would be another provision to give the ‘adjustment required or authorised by law’ to prevent deposits from being treated as a cash basis receipt at the time of initial receipt. However, I was unable to find such a provision.
It is not known whether this is because HMRC considers that a deposit is not ‘a receipt of the business’, as the landlord is not necessarily entitled to retain it. If that is the case, does that also mean that it is deemed that the receipt only happens when the landlord has a legal right to retain the money? It has not been possible to confirm the reasoning behind the wording of the draft legislation owing to restrictions in place during the pre-election period.
Advisers and eligible unincorporated landlords who are planning to adopt the default cash basis for the 2017/18 tax year onwards should keep an eye on how the legislation unfolds. Given that concerns have been flagged to HMRC on the interpretation of the draft legislation in respect of deposits, it will be interesting to see whether the legislation will be amended or whether HMRC will issue further guidance on how the legislation should be read.
This article was first printed in Property Tax Insider in June 2017.