Most landlords (and even some accountants) are unaware that there are two methods thatcan be used to calculate your annual UK property income tax. These methods are known as ‘Cash Basis’ and ‘Earnings Basis’.
In this article we will explain when and how both methods can be used.
To demonstrate each of the methods the following case study will be used:
Louise owns one buy-to-let property, which generates an annual rental income of £12,000. The rent is paid six months in advance and runs from 1st January 2004 till 31st December 2004.
This means that she receives £6,000 in rental income on 1st January 2004 and £6,000 on 1st July 2004. The 1st January 2004 rental income covers the period 1st January to 30th June and the 1st July 2004 rental income covers 1st July to 31st December.
She also has some roof repairs carried out in the property in March 2004. The cost for the work done is £1,000. However, the builder is a little slow in billing and he does not raise the invoice till May 2004, which Louise promptly pays.
The cash basis can be used when the income generated from your property rental business (before allowable expenses are deducted) do not exceed £15,000 in the tax year.
When the cash basis is used, the income tax calculation is based on when the rent was actually received and when expenditures were paid. Note here that the emphasis in this method is on ‘received’ and ‘paid’. In other words it is based on when money exchanges hands.
Louise completes her tax return using the ‘Cash Basis’ method
When she completes her tax return the rental income will attributed to the tax years as follows:
Rental Income Received
2003-2004 tax year rental income is £6,000. This is because the first payment of 1st January 2004 lies in this tax year.
2004-2005 tax year rental income is also £6,000. This is because the second payment of 1st July 2004 lies in this tax year.
The roof repair work was carried out in the 2003-2004 tax year, as it was carried out in March 2004. However the invoice was not paid till the following tax year. This means that Louise will only be able to offset the expenditure against the 2004-2005 tax year as this is when the invoice was paid i.e. May 2004.
The Inland Revenue gives the following conditions in paragraph 91 of the IR150 Manual.
We are, therefore, prepared to accept the use of a ‘cash basis’ (profits based on the cash paid and received in the year) provided all the following conditions are met:
· the case is small; by a ‘small’ case we mean one where, for any year, the total gross receipts of your rental business (before allowable expenses are deducted) don’t exceed £15,000; and
· the ‘cash basis’ is used consistently; and
· the result is reasonable overall and does not differ substantially from the strict ‘earnings basis’
The earnings basis is also sometimes referred to as the ‘accruals basis’ and follows ordinary commercial accounting methods. When using this method, there are two very important points to note:
Firstly – You can use this method regardless of whether the income generated from your property rental business (before allowable expenses are deducted) exceeds £15,000 in the tax year. In other words, if your annual rental income is below £15,000 per year, then you can still use this method. However, if it is above £15,000 then you must use this method.
Secondly - The income tax calculation is based on when the period rental income arises and when expenditures were incurred. Note here that the emphasis in this method is on ‘arises’ and ‘incurred’ which is different to the cash basis method.
Let’s continue with the case study:
Louise completes her tax return using the ‘Earnings Basis’ method
When she completes her tax return, the rental income will be attributed to the tax years as follows.
Rental Income Received
As we know, £6,000 was paid for the first six months that the tenant lived in the property. The upfront £6,000 payment on the 1st January 2004 was to cover the period 1st January to 30th June. However, this payment covered both the 2003-2004 and 2004-2005 tax years.
Therefore the £6,000 rental income needs to be apportioned across both tax years, as the rental income attributable from 1st January to 5th April will be recorded against the 2003-2004 tax year and the income attributable from 6th April to 2oth June to the 2004-2005 tax year.
Here is how the apportionment could be done:
Daily Rental Income
£6,000 was due for 181 days (i.e. 1st Jan to 30th June).
This means that the amount charged per day = £6,000 / 181 = £33.15
Rental income for 2003-2004 tax year
The number of days from 1st January to 5th April inclusive = 95 days, and 95 * £33.15 = £3149.25.
Therefore £3,149 is attributable to and recorded against the 2003-2004 tax year.
Rental income for 2003-2004 tax year
The remaining rental income from 6th April to 30th June is attributed to the 2004-2005 tax year. This amount is £2,850.75.
Also, the entire rental income of £6,000 that is paid on 1st July is also attributed to the 2004-2005 tax year. This is because it covers the period 1st July to 31st December. This entire period sits within the 2004-2005 tax year.
Even though the payment for the roof repair work was made in May 2004, the work was actually carried out in March 2004. This means that because March falls within the 2003-2004 tax year the £1,000 cost will be attributed to this tax year.
As you can see, it is beneficial to offset the cost in this tax year rather than waiting till the following tax year.
Comments about the Earnings Basis
Here are some important points to note when using this method.
· This method must be used if your gross income exceeds £15,000 per tax year. However you can also decide to use it even if your income is less than £15,000.
· In the case study we calculated the amount due for the five odd days in April. The Inland Revenue does allow a concession here to simplify the computation. The concession allows you to ignore the split if you do it consistently across both income and expenditures and the figures are small. The strict daily apportionment is required when the figures are ‘substantial’. Please note that there is no indication given by the ‘Inland Revenue’ as to what is meant by ‘substantial’.
· As you have seen here we are not working on the basis of what was paid or received. Therefore, if a tenant did not actually pay the rental income that was due, then you would create a bad debt to offset this against the rental income.