From an income tax perspective, the income derived from land and property in the UK is treated as coming from a single UK property rental business. This means that the income from all properties, regardless of whether they are let furnished or unfurnished or whether they comprise of furnished holiday lettings, is treated as coming from a single rental business. This has a number of advantages. As well as simplifying matters from an administrative viewpoint, it also means that expenses from one property can be set against income from another property as everything is effectively mixed together in one pot.
Trading Rules Apply
Although income from property is not taxed as a trade, the same rules are applied in computing the profits for the property rental business. This means that in order for expenses to be deductible they must satisfy the same tests as if they were incurred for the purposes of a trade.
Wholly and Exclusively Rule
Expenses are deductible in computing the profits of a property rental business to the extent that they are wholly and exclusively incurred for the purpose of the business and are not capital in nature. As trading rules are adopted for the computation of profits and losses of a property rental business, the same considerations apply to property rental businesses as to trades in determining whether an expense is deductible.
For an expense to be deductible, the sole purpose of that expense must generally be a business purpose. Strictly speaking, any non-business or private purpose will jeopardise the deductibility of the expense as in many cases it will not be possible to distinguish the business element from the non-business element.
However, where a definite part of proportion of the expense is wholly and exclusively incurred for the purposes of the business, HMRC will allow a deduction for the business part or proportion.
Business Purposes and Uncommercial Rents
The need for an expense to be incurred wholly and exclusively for the purposes of the business can have a rather nasty side effect where the property is let at a rate that is less than the market rate.
HM Revenue and Customs take the view that unless the landlord charges a full market rent for a property and imposes normal market lease conditions, it is unlikely that the expenses of the property are incurred wholly and exclusively for business purposes. Where a property is let at a rent that is less than the commercial rate or the property is occupied rent-free, for example by a relative, the assumption by HMRC is that the expenses are incurred for a personal or philanthropic reason (namely that of providing the occupant with a home) rather than for a business purpose. This has implications for the deductibility of those expenses.
If a strict approach is adopted, expenses that are not incurred wholly and exclusively for the purposes of the business are not deductible in computing the profits of that business. However, HMRC do not take that harsh a line and where a property is let at a rate that is less than the market rate they permit expenses to be deducted up to the value of the rent. This means that the expenses cannot create losses and excess expenses cannot be carried forward to be used in later years or set against the income from other properties in the rental business. If expenses exceed the rent for a property that is uncommercially let, the result is that the property produces neither a profit nor a loss. No relief is given for the excess expenses.
Billy lets a flat to his brother. The commercial rent for the flat is £600 per month, however, Billy’s brother only pays £300 per month.
The property is let throughout 2006—07. In the tax year, expenses incurred in relation to the property were £4,000.
The rental income received by Billy in 2006—07 from the flat is £3,600. As the rent is less than market value, expenses can only be deducted to the value of the rent received. The expenses in the year (£4,000) exceed the rent received, so the expenses are deducted so as to reduce the profit to nil. The excess expenses of £400 (£4,000 - £3,600) cannot be set against the income from any other properties that Billy may have nor can they be carried forward for relief against future rental income. Any relief for these expenses is lost as the property is let at less than market rent.
Where a property is let at a commercial rate, there is no such restriction on the amount of expenses that can be deducted. Where expenses for property let at market rent or above exceed the rent, a loss is created for which relief can be obtained against other rental income. This is not the case where the property is let at an uncommercial rate.
Whilst some relief for expenses is available if a low rent is charged, the position is completely different if the property is let out rent-free. Properties that are let rent-free are outside the scope of the property income regime. To be within the regime, there must be a source of income. There is no source of income if no rent is charged and as the property is not within the property tax regime, there is no associated deduction for expenses. Without a business, expenses cannot be incurred for the purposes of the business. This means that any expenses incurred in relation to a property let out rent free cannot be relieved.
In the event that a property is let commercially for part of the year and at a low or zero rent for another part, the extent to which expenses are deductible will depend on the circumstances. If the property is continually available for letting and a relative merely house-sits in unoccupied periods, expenses will be deductible in full. However, if the property is unavailable for letting for certain periods because it is being used by friends or friends or relatives rent-free for certain periods, the expenses will be apportioned between commercial and rent-free lets and relief given for those relating to periods when the property was commercially let.
Think before you let
Landlords should think carefully before allowing friends and relatives to use a property rent-free as this will not only reduce the income received from the property but will also affect the extent to which expenses can be deducted. Expenses are only deductible where they are incurred wholly and exclusively for the purposes of the property rental business. If the property is not available to generate income, there is no business and any deductions for expenses are lost. The key is to make the property available for letting at all times and only allow friends and relatives to use it on the understanding that they vacate should a commercial rent-paying tenant become available.