Tax implications of three property rental schemes for retirement income

Tax Law Letter

Mr. And Mrs. Bob and Anna Diamond

I would like to start by thanking you for entrusting me with guiding you as you plan this next phase of your financial growth. Tax considerations are an important part of ensuring your financial independence and security at any time, and after retirement they can become some of the most significant factors and forces of change in a family's financial position. It is wonderful that you are pursuing your various options in such a considered and careful manner, and I am more than happy to help you in this process of growth and change in your lives.

It is my understanding that you are considering several different property purchases and other methods for generating income through the renting of properties you do or will own. Specifically, you are exploring the possibilities of letting out rooms in the house that you currently occupy, during school terms and on a non-renewing basis; furthermore, you are also considering the purchase of a seaside cottage to be let out on a short-term basis to holiday makers; finally, you are seeking to purchase several standard housing units for long-term rentals to residential tenants. It is also my understanding that these purchases will be made largely or entirely with cash already in your possession, primarily from an inheritance received following the passing of a relative. If I have erred in my assessment of your situation and considerations, please do let me know right away, as any change could affect the reliability of the information I can impart to you.

There are three distinct types of property purchases and rental schemes that you are exploring, and each of them is treated differently for tax and income purposes. Some of the laws regarding rental income taxes and general property taxes will be applicable in more than one of these areas, but overall tax liabilities and structure vary from standard residential rentals (i.e. The long-term tenant-occupied properties you are considering), furnished holiday rentals (assuming you plan on furnishing the seaside cottage you will be renting to holiday makers, which is pretty much a necessity in order to actually find tenants), and renting rooms in an owner-occupied home. By considering each of these specific areas separately, you will gain a better understanding of the tax liabilities for each specific type of property investment, and will be better able to select a mix that works for your situation and goals.

Residential Lettings

The income obtained from standard long-term residential rentals has a specific tax structure in the United Kingdom, generally treating any profits received from the business simply as additional income taxed at the same rate as your normal income. For residential lettings of this type, all properties are considered part of the same business, and thus contribute to the same income. This also means that losses from one property can be used to offset profits on another property, meaning taxes will only be assessed on total overall profits.

There are certain complications to the taxes assessed on rental property income, however, and it is through an understanding of these complexities that savings can be generated in this particular scenario. Specifically, understanding the allowable expenses from income received through letting can greatly reduce the tax burden that you will incur form this income. When calculating the net profit obtained fro rental income, there are several areas where deductions can be made before the income is started as profit. These deductions represent the greatest tax savings, as they are removed before the income from letting properties is ever even counted as income by Revenue. Other expenses related to letting can be listed as tax allowances, but this occurs after these amounts are counted as income and thus are not as beneficial from a tax savings perspective.

Allowable deductions before letting income is counted as profit include letting agent's fees, legal fees incurred for lets of a year or renewals (as long as the terms of the lease are for a period of less than fifty years), accountants fees, insurance, interest on loans, maintenance and utility payments, Council Tax, and a list of other specific direct costs. Some of these expenses are less applicable to your situation than others, but you should consider these options carefully; it might be to your advantage to fund your property purchases through the use of borrowed funds, as the interest is tax deductible and could allow for more purchases and greater profitability, for instance.

Allowances for capital costs -- indirect costs associated with letting properties -- can also be deducted from the final taxed amount, though the savings here are not as significant for these costs. Generally speaking, fifty percent of capital costs such as construction of new properties or additional property, new machinery or equipment, and supplies used for maintenance activities like gardening and cleaning can be deducted. For certain qualifying environmentally friendly purchases, one hundred percent of capital costs can be deducted from the tax amount, but these are very special cases and must be items specifically approved for this full allowance in order for the one hundred percent deduction to apply instead of the standard fifty-percent. Wear and tear allowances on the property itself, in amounts based on specific percentages of the rent being charged and property features, can also be deducted.

Room Letting

When it comes to letting rooms in your own room, there are two methods that can be employed (everything following assumes that the rooms are still fully a part of your home, and that you have not converted your home into separate flats, but I do not believe that is your intention). Income received by letting rooms can be treated the same as any other letting income, with the same allowable expenses and tax allowances as a residential letting and the rental income simply added to other income sources and taxed. The government allows for another scheme, however, in which up to 4250 GBP can be received tax free for room letting. This option does not allow deductions for any expenses and the tax-free income limit includes any income received for services such as meals or laundry, but it is often still advantageous to use what is known as the Rent a Room scheme. Assuming the total rental income will be positive (that is, that there will not be a loss) and that it will not exceed or at least greatly exceed the income limit, it will almost certainly be advantageous to use this scheme.

Summary

I hope the above information is useful to you as you consider your options. Letting rooms is a fairly easy way to earn some income without needing to worry about the tax implications under the Rent a Room scheme. Deciding what property to purchase and how to derive income form is something that should come after a consideration of several options. This information should make those considerations more fruitful.

Sincerely,