Simplifying income tax for residential landlords – latest developments

Heather Britton discusses the Office of Tax Simplification’s report on simplifying income tax for residential landlords

This article was first published in Taxation magazine on 17 November 2022

Key points:

• The Office of Tax Simplification’s penultimate report focuses on property tax income for individuals
• Areas for reform include the potential abolition of the furnished holiday letting rules
• Could a ‘brightline’ test provide clarity to trading?
• The tax rules have led to increasing numbers of corporate owners
• The rules for spousal ownership and form 17 are ripe for reform
• The capital versus revenue debate continues

On 1 November 2022 the Office of Tax Simplification (OTS) published its report on simplifying income tax for residential landlords. As nearly one in 10 UK income taxpayers have income from property this is an issue of interest to many clients and their tax advisers.

The OTS report runs to 113 pages and covers a multitude of areas including ownership and financing, allowances and reliefs, treatment of certain expenses (primarily focusing on repairs), the furnished holiday lettings regime, Making Tax Digital for income tax and ownership of UK property by non-UK residents. The executive summary states that “residential property is an unusual asset class, in that it can be treated for tax purposes as a place to live, an investment, a business, or even as a trade, with quite different tax consequences”.

Some landlords make a deliberate choice to buy property to rent out, however many others will become a landlord by circumstance, for example by renting out their previous home or through inheriting property.

The OTS report includes interesting comments on the history of some of the current rules, highlights inconsistencies or challenges within the current legislation, as well as recommending some areas for reform or where HMRC guidance could be improved. This article focuses on four themes arising from areas covered within the report, including comments on the potential abolition of the furnished holiday letting rules and a potential alternative ‘Brightline’ test, property incorporation, spousal ownership and the timeless issue of capital vs repairs.

Furnished holiday lettings

The furnished holiday lettings (FHL) regime gives certain tax advantages over the wider residential property income rules for short term lettings meeting certain conditions; mainly relating to availability for letting, and days actually let, each year. The foundations of the FHL regime start with the property income rules, but then ‘cherry picks’ certain elements of the trading rules such as certain income tax and capital gains tax reliefs. Some of the key benefits for properties qualifying as FHLs are as follows:

• interest incurred on borrowings is fully deductible against taxable profits
• capital allowances (or a deduction if cash basis is used) for fixtures, furniture and white goods
• profits from FHLs can be treated as relevant earnings for pension purposes
• income from a FHL held jointly by a married couple or civil partners is not caught by the default 50:50 split for income tax purposes (see further below). Instead income can be split as the couple decide
• various capital gains tax reliefs also apply, including potential for business asset disposal relief (10% rate on sale), rollover relief and gifts hold-over relief

Based on 2019/20 statistics from HMRC, around 127,000 FHL businesses owned by individuals are declared to HMRC in personal tax returns. Given some respondents felt this represents a fairly small core of people running a substantial short-term letting business, and a long tail of second-home owners renting one property, the OTS recommends the Government should consider whether there is a continuing benefit to separate tax rules for FHLs or whether they should be abolished.

It may be useful to understand a bit of the history here. The FHL rules were introduced in 1982/83 to provide clarity over whether operating a short-term holiday rental business would be treated as a trade for tax purposes. This issue is particularly relevant in areas such as the South West with a large number of holiday lets. The new legislation did not treat the activity as a trade but provided that such income would be taxed as trading income rather than income from investments. The day count tests were originally lower than currently (70 days actual letting and 140 days availability). Originally the property had to be located in the UK but in 2009/10 the regime was extended to include properties in the European Economic Area (EEA) to be compliant with EU free movement principles.

If the FHL regime is abolished the recommendation from the OTS is that the Government considers whether certain property letting activities subject to income tax should be treated as trading and whether it would be appropriate to introduce a statutory ‘brightline’ test to define whether a property trading business is being carried on.

There is no general legislative definition of trade, instead relying on the ‘badges of trade’ set out by the Royal Commission of the Taxation of Profits and Income in 1955 alongside subsequent case law. In relation to property income this normally boils down to two principal factors: whether the landlord is in actual occupation of the property and whether the services provided are beyond those normally provided by a landlord, e.g. hotel, guest house or bed and breakfast.

The OTS report outlines a suggested ‘brightline’ test to provide a clear test for when property letting activities subject to income tax would qualify as a trade. It proposes possible factors to be considered within the test are:

• minimum number of properties let
• letting is on a short term basis
• no personal use of the let
• level of personal time devoted to the property letting and services provided

Whilst it is noted that a ‘clear’ test is sought, any test is likely to involve consideration of a multitude of factors, some of which may carry more weight than others and there is likely to remain a level of judgement. The OTS report also suggest that the ‘brightline’ test could be considered in relation to establishing whether a business is eligible for business property relief (now known as business relief) for inheritance tax purposes or incorporation relief for capital gains tax purposes as well as aligning National Insurance to the income tax status.

The Upper Tribunal case of Elisabeth Moyne Ramsay [2013] UKUT 0226 (TCC) is normally used in providing guidance in relation to incorporation relief for CGT purposes. Given most recent inheritance tax cases have found that business property relief is not normally available to the majority of furnished holiday let owners (unless the level of additional services is so high that the activity can be seen as non-investment) any such shift could mean that some holiday let owners running substantial businesses may start to achieve inheritance tax protection if such a test were introduced. It is likely that any change making this more likely would be resisted.

Should the Government conclude that the FHL regime should be retained then the OTS recommends removing the current distortion of allowing the regime for properties in the European Economic Area (EEA), either by permitting worldwide properties to qualify, or by limiting the scope of the regime to UK properties. A further recommendation was made to restrict the regime to properties used for commercial letting by removing or limiting the potential for personal occupation.

Incorporation

Individuals who are landlords of residential properties are subject to restrictions on the deductibility of interest (unless run as a FHL). They are also subject to income tax on profits as they arise (either on the accruals or cash basis), regardless of any amounts required (or drawn) from the rental business. These interest restrictions do not apply to companies and there are other perceived tax and commercial advantages which have led to more interest in corporate ownership of property in recent years. Whilst this OTS report was focusing on property income received by individuals, some comments were provided on corporate ownership and incorporation.

Following the announcements of interest restrictions in 2015, there has been an increase in the number of property incorporations and those choosing to use a corporate structure. For some taxpayers, there may not be the substantial tax savings envisaged. However, for higher and additional rate taxpayers where there is not the desire to extract funds but most is used for repaying debt and reinvestment, there can be merit. However, the increases in corporation tax rates from 1 April 2023 may reduce any overall tax savings going forward. For basic rate taxpayers or those wishing to live off the property profits, the impact of double taxation (corporation tax on rental profits or capital gains and then income tax on extraction of funds from the company) means the incorporated position may not be beneficial for tax purposes.

In order to incorporate many will face the substantial tax costs of stamp duty land tax (SDLT) unless they fall within the partnership rules and capital gains tax, unless they have a business and the incorporation relief route is used. Many will face practical issues in relation to debt on incorporation and ensuring this is considered at an early stage is vital.

Spousal joint ownership & form 17

The OTS report comments on HMRC data which indicates that almost half (1.5 million) of all taxpayers renting out property do so jointly, mainly with a spouse or civil partner.

Where taxpayers are not married or in a civil partnership, the default position is that the income is normally taxed on beneficial ownership proportions but the owners can instead choose any other split they like without any form of tax election. Care should be taken in the situation where there is a partnership as any changes in income shares in a property investment partnership (PIP) may have stamp duty land tax (SDLT) implications.

Compare this situation to that of spouses and civil partners. The default position is that income is split equally between them for income tax purposes (except in the case of income from a FHL). If the property is held as tenants in common and beneficial ownership is not equal, and each spouse’s entitlement to income is the same as their shares of beneficial ownership, they can choose to elect for the income to be split in these proportions for tax purposes. This joint election is made to HMRC on form 17 (‘declaration of beneficial interest in joint property and income’) and must be submitted along with evidence of beneficial ownership. The election must be submitted within 60 days of the date the form is signed.

A further complication which is often not appreciated is that, where the legal interest is in the name of one spouse only, but the beneficial interest is held jointly, form 17 does not apply. In this situation the income tax treatment would follow the beneficial ownership outlined above without the need for an election.

For capital gains tax purposes, gains and losses are split according to the beneficial ownership of the property regardless of the relationship between owners.

When independent taxation was introduced in 1990/91 one of the aims was to ‘offer all married women the opportunity to enjoy independence and privacy in their own tax affairs’. This default 50:50 income tax rule for property is noted in the report as being an ‘anachronistic rule’. The fact that married couples need to enter into an election to get into the same default position as other owners seems outdated. The OTS recommend the 50:50 spousal rule is removed and align the tax treatment to that of other joint owners. To prevent abuse, they suggest the default beneficial ownership position is not capable of being displaced by another split of choice.

The report later goes on to consider how joint property owners will be impacted by the Making Tax Digital (MTD) for income tax rules which are due to be introduced from April 2024. They recommend that HMRC should establish a system for dealing with jointly owned properties, for example by making a jointly owned property the MTD filing entity. This is particularly important given nearly half of landlords will be filing in relation to jointly owned property. This, along with recommendations to increase the minimum gross income threshold above £10,000 as well as allowing MTD agents to be authorised alongside tax agents, all lead to the sensible recommendation that the April 2024 implementation date for landlords should be delayed.

Capital vs income

There have been different ways over recent years to obtain tax relief on domestic items such as furniture and non-fitted white goods. Various regimes have come and gone which has vastly increased the complexity in this area. These include a renewals basis repealed in 2013 and the 10% wear and tear allowance for furnished property which was repealed in 2016. Capital allowances are not available for fixtures or furniture for use in residential property unless it is within the FHL regime.

The current regime for the replacement of domestic items is closer to the pre-2013 renewals basis. Items such as replacing an integrated kitchen or bathroom sanitaryware will be allowed as a repair and replacing freestanding appliances or furniture allowed under the replacement rules. Complexities remain as there is still a distinction between improvements and replacements.

There are particular complexities when considering the boundary between repairs and improvements to a property. For residential landlords they will only achieve a deduction from rental profits if the work is allowable as a repair. The position can be unclear where the work significantly alters or is an improvement on what was previously there. The use of modern materials, as may be required by current building regulations, may give a perceived element of improvement, but if in reality the work results in the asset being used as before and it does not do a significantly different job, then this is likely to be a repair and not an improvement. HMRC accept that where the nearest modern equivalent is used, for example replacing lead pipes with copper or plastic pipes, such work would normally be treated as being a repair.

Some landlords will be aware that their properties may need some improvements due to changing regulations. Energy Performance Certificates (EPCs) report on energy efficiency and environmental impact rating of a property. The rating scale is from A (being the best) to G (being the worst). Most let UK residential properties (except holiday lets) must currently have a minimum rating of E. There are proposals for properties in England and Wales that the EPC rating will be a minimum of C for new tenancies by 2025 and all new tenancies by 2028. Whilst there may be a cap on the maximum spend landlords will be expected to invest, is it fair that some expenditure may achieve tax relief (e.g. replacing single glazed windows with double glazing) whereas the addition of insulation where there was none before may potentially be treated as capital?

The OTS report goes on to suggest a potential wider approach for repairs that would allow many more items to be deducted unless on initial fit-out after purchase (if unable to let out) or, say an extension, which would change the fundamental character of the property.

However, if consideration is given to changing the rules for repairs for residential properties owned by individuals, should similar rules also be introduced for furnished holiday lets, commercial property or any property owned by a company?

In conclusion

The points discussed above touch the surface of some of the issues and recommendations arising from the OTS review into residential property income for individuals. Any potential changes would also need to consider other types of properties, for example commercial property, or other ownership structures, for example partnerships or companies.

Several previous OTS reports have led to little change as they appear to fall into the ‘too difficult’ pile. This is the OTS’s penultimate report because it is due to be disbanded following a final report due later this year.

Given the vast number of areas touched on in this report, I would personally expect to see a few tweaks – for example, delays to Making Tax Digital (MTD) for income tax for landlords whilst various issues are ironed out, and potentially in relation to the removal of the outdated 50:50 rule for spouses – but fear that any greater reform may be pushed further down the road.

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