Common misconceptions about tax when owning a rental property

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In some ways being a tax advisor is a bit like being a doctor – at every party someone has a tax question to casually mention over a drink. During these encounters it’s become apparent to me that people aren’t dealing with profits, or capital gains, on rental properties correctly.

The most common misconceptions I hear time and time again are;

I don’t need to do a tax return because the rental income gets paid into my wife’s account.

This is not true. When a property is jointly owned between married partners the rental profits are automatically taxed 50:50, irrespective of whose bank account the money goes into (and irrespective of who spends it!). The only way to override this automatic 50:50 split is to change the ownership of the property into a ‘tenants in common’ basis, and then by formal declaration to assign different proportions to each of you on HMRC form 17. In the absence of this formal procedure the rental income & expenses are automatically taxed 50:50 and both parties should be reporting their share to HMRC and doing a tax return.

It is a tax planning point to consider each partner’s marginal tax rates and decide to formally split the profits accordingly.

I don’t have to do a tax return because I’m not a taxpayer, or I don’t have to do a tax return because my mortgage is more/the same as the rental income

This is not quite true. Sometimes a person’s only source of income will be rent from a rental property and their state pension. Where these aggregate to less than the tax free personal allowance (which is £12,570 in 2022/23) the person believes that there is no tax, so consequently no obligation to report the income to HMRC and no tax return to do.

HMRC’s Self-Assessment criteria requires that if rental profits exceed £2,500 then you have to report the results on a tax return, even if that £2,500 profit is covered by a tax free personal allowance.

Additionally many people self calculate their profits to conclude that they have a loss. The first step in their calculations is rent minus mortgage. Where this is negative they consider that they do not have any reporting obligations. This is wrong for three reasons.

Firstly, if rental income (before expenses) is over £10,000 then a tax return is required.

Secondly, it is only the interest element of the mortgage which can be offset against the rental profits. Any capital repayment element cannot be deducted.

Thirdly, we are now in a tax regime where mortgage interest is not deductible from rents when arriving at the taxable profits. Instead a credit (of 20% of the interest cost) is given against the taxpayer’s tax bill. For basic rate taxpayers this effectively gives the same result, but it can affect whether profits cross the threshold of reportability in the first place.

I won’t have any capital gains tax because I used to live in it for those few years before I …  or I won’t have any capital gains tax to pay if I move back in just before I sell it (this one is often followed by a wink and a smirk)

I am often met with surprise (shock and panic) when I explain that the main residence exemption is not a binary concept. People believe you either get it or you don’t; the property is either entirely exempt (if you’ve lived in it at some point) or entirely subject to capital gains tax (if it has always been a rental). This isn’t the case. The reality lies in between, with a proportion of the capital gain being exempt, and a proportion of the capital gain being chargeable. These respective proportions are calculated by considering the relative lengths of time that the property was the person’s main home, or wasn’t.

This binary expectation leads many people to believe that if they used to live in a house, then rented it out, it always remains completely exempt from capital gains tax. Similarly if they have an investment property, they believe they can ‘trick’ the system by moving back in to sell it. Neither of these ideas are accurate, and comes as quite a shock to some people who had not considered any capital gains consequences of selling a former home.

I won’t have any capital gains tax because I did lots of work to the house, and my time is worth something, and saved me actually hiring a builder who would have charged £15,000 etc...

It’s hard to dispute the logic of this one, time is money after all.
In business transactions, most items of expense for one person is someone else’s income. Even if you undertook renovation building work yourself, self-evaluating it to be worth £10,000, you cannot pay yourself for it. Suppose you could, hypothetically, then you should have reported the income side of it as taxable income and you would then have tax & NIC on the income. Notwithstanding the lack of legal foundation to bill yourself, it just doesn’t make good tax planning!

I won’t have any capital gains tax to pay if I give the property to my son/daughter

Capital gains tax is based on how much you sell the property for. In some circumstances the actual sales value can be replaced with the property’s market value. This is done when the transaction is not a “bargain at arm’s length” and also when transferring to someone who is connected to you (broadly close family/relatives).

So, there you have it, some of the biggest misconceptions on rental property tax I have come across. Have some questions? Get in touch with our expert team of Chartered Accountants today on 01244 343 504.