As Property Tax Insider readers know, landlords come in different guises and much has been made in the press concerning of one group in particular - the ‘accidental landlord’ - namely homeowners who have inadvertently gained two properties because they did not want to sell at a loss and have therefore rented one rather than sold.
According to The Landlords Association these property owners now appear to have exited the market, supposedly leaving professional landlords to pick up where they left off. But there is another type of ‘accidental landlord’ about which little has been written – they also did not set out to own two properties but have had to purchase a second, in order to house a relative who does not have the funds to purchase the property themselves.
Renting to relatives is becoming prevalent in University cities for example, where parents are buying flats for their student children unable to find suitable student accommodation and is also to be found in seaside towns where children are buying houses for their elderly parents, unable to afford their own homes.
Income Tax Implications
Many understand the Capital Gains Tax (CGT) implications on the sale of a second property but few are aware that there are also income tax implications should the property be rented to a ‘connected’ person either ‘rent free’ or at an amount deemed to be at less than the market rate.
The remainder of this article details these rules. If the property is rented to an unconnected independent tenant, even at a rent less than the market rate, the usual rental calculation is required and the following rules do not apply. We therefore first need to ascertain who is a ‘connected person’ in the eyes of HM Revenue and Customs (HMRC) and what is meant by ‘market rate’.
Who is a ‘Connected’ Person?
HMRC define a ‘connected’ person very widely to include:
- a husband, wife or civil partner
- brothers, sisters, parents, grandparents, children, grandchildren and their husbands, wives or civil partners
- the brothers, sisters, parents, grandparents, children, grandchildren of the husband, wife or civil partner and their husbands, wives or civil partners
What is ‘Market Rate’?
Obviously, HMRC do not have the legal power to tell a landlord how much rent to charge, however, if a property is rented to a ‘connected’ person it is likely that HMRC will ask for confirmation that the rent being charged is at a commercial/market rate. This ‘market rate’ figure can easily be found by use of such websites as ‘Rightmove’ but HMRC will require written confirmation which can be obtained from a reputable local letting agency.
General Income Tax Implications
If the tenant is ‘connected’ to the landlord and pays an amount at less than the market rate then HMRC will enforce the rules which centre round the amount of expenses that can be claimed as a deduction from the rental income received.
The full amount of expenses incurred will not be allowed. However, as a concession HMRC will allow the landlord to claim a total amount restricted to the rental income derived from that property. Expenses incurred in excess of this figure are not allowed to create a loss, neither can they be carried forward to be utilised in any future year; they are, therefore, wasted.
Tax Implications if Let at Market Rate for Part of the Tax Year
The total expenses amount that can be claimed in these specific circumstances will depend upon the number of months and frequency of the letting.
As a guide, HMRC’s Property Income Manual confirms that ‘ordinary house sitting by a relative for, say, a month in a period of three years or more will not normally lead to a loss of relief. On the other hand, relief will be lost if, say, the relative is really just taking a month’s holiday in a country cottage.’
Otherwise the claim is restricted to the amount of rent received for the specific part of the year when rented to the ‘connected’ person; any expenses incurred relating to the same property when rented to an unconnected person during the remainder of the year will be allowed in full.
There may be other circumstances when a ‘connected person’ stays at the property - for example, for security reasons - to ensure that the property remains ‘squatter-free’. This occupation will not invalidate any claim for expenses incurred so long as they relate to the rental business itself and have not been incurred for the occupiers’ personal reasons.
What is most important is that the property be available for commercial letting whilst the ‘connected’ person is in residence and therefore the property must not be withdrawn from the letting agency who must still try to find a tenant.
Tax Implications for the Professional Landlord
If the landlord is in the business of renting other properties as well as the one being rented to a ‘connected’ person at less than the market rent, it will be tempting to deduct any unrelieved expenses against the other rental income.
Unfortunately, this is not possible as HMRC require all properties rented to a ‘connected’ person at below market value or rent free to be ‘ring fenced’.
Hence unrelieved expenses on those properties cannot be offset against profits made on other commercially let properties.
However, a professional landlord may incur general overhead expenses in the running of his business. For example, there may be employees who repair and decorate all of the properties in the portfolio as and when required.
If this is the case, the expenses incurred (wages, in this example) need to be apportioned between the two different types of property on a reasonable basis possibly using an hourly basis split. If this method of calculation produces a total excess of expenses relating to the property rented to the ‘connected’ person then this excess is lost.
Wear and Tear Allowance
Property let furnished attracts a 10% ‘wear and tear’ allowance (for details see Property Tax Insider, Issue 2, October 2010 – ‘How to Claim the 10% Wear and Tear Allowance’). This allowance can also be claimed for a property let to a ’connected’ person using the same calculation of 10% of net rent and this amount is added to the other expenditure incurred on that specific property (i.e. charges and services).
Should the landlord not want to claim the ‘wear and tear’ allowance the alternative is the ‘Renewals Allowance’. Whichever allowance is used, the total expense amount is still restricted to the amount of rent received.
Property Let Rent-Free
Finally, if the property is occupied completely rent free then technically it falls outside of the lettings regime. This is not as good as it sounds because any expenses incurred by the landlord will be wasted as there is no rent against which to offset the expenses. The reason for this treatment is that HMRC view any such expenses as not being incurred ’wholly and exclusively’ for business purposes.
Just because the landlord and tenant are ‘connected’ does not mean to say that the landlord should dispense with such basic legalities as the production of a signed tenancy agreement. The fact that the claim for expenses relief against rental income received may be restricted makes this even more important.
By Jennifer Adams