While capital gains tax (CGT) can come as a nasty and painful surprise, it is, in the end, a one-off nasty and painful surprise. Income tax, on the other hand, is an annual attack on rental profits and a permanent source of misery. The tax rates for 07/08 are 10%, 22% and 40% (the non-savings rates) depending on income level. From April 2008 the 10% rate disappears, the basic rate falls to 20% and the higher rate stays at 40%. But it is not all bad news.

Like CGT, income tax can be mitigated in a number of ways by using the standard reliefs and allowances available to everyone who has an income from property.

MORTGAGE INTEREST

By far the most important of these, for most investors, is the interest paid on the mortgage taken out to buy the investment property. In most cases this will be a buy-to-let mortgage (see Chapter 4). Unlike, therefore, the interest paid on a residential mortgage (which attracts no tax relief at all), 100% of an investment mortgage interest is allowable and can be offset against rental income.

There is a further bonus for the investor who raises finance for rental investment on his own residential home. So long as the purpose of the mortgage (or remortgage) is to invest in rental property, the interest on this, too, is an allowable expense. This is despite the fact that a residential mortgage does not attract tax relief. Only the amount raised for investment purposes, however, is allowable.

Finally, it should be noted that only the interest on the mortgage is tax deductible. Capital repayments do not qualify for tax relief.

OTHER MORTGAGE COSTS

Some other costs, associated with obtaining the investment mortgage, are also allowable:

• A broker’s fee.
• The lender’s arrangement fee.

Note, however, that the cost of the valuation required for the purchase is not an allowable expense for income tax purposes. It can, however, be used to mitigate the CGT on resale (see Chapter 28).

REPAIRS AND MAINTENANCE

As might be expected, ongoing repair and maintenance costs can be offset against rental income. If the work prevents the property from deteriorating, the cost is allowable. The costs of maintaining boilers, repairing leaking radiators, patching up the roof, fixing the fence, painting (inside and out), repairing furniture, treating damp, etc. are all allowable expenses. Keep all invoices and receipts.

A distinction, however, needs to be made between these costs and the cost of improvements. A new bathroom, for example, is an improvement. A loft conversion is an improvement. These costs can be taken into account on the sale of the property and can mitigate the CGT liability (see Chapter 28) but cannot be used to reduce the tax on rental income. Nor is it possible to claim the notional cost of a repair you won’t now have to make because of the new bathroom you have installed!

An exception may be made where the improvement is of such a nature as to bring the property up to acceptable living standards for houses and flats. Double glazing might be considered one such improvement. If in doubt, call the Inland Revenue Helpline (0845 9000 444) and ask. It follows, of course, that what is allowable against income tax cannot be used later to offset CGT.

PRIOR TO LETTING

Unfortunately the Revenue has little sympathy for you here. The cost of getting the property into shape before letting is not allowable. However, the cost of advertising is, as are the fees charged by an agent, if you use one.

10% WEAR AND TEAR

This applies to the furniture and furnishings (not the fittings) in furnished rental property. Some 10% of the annual rental income can be claimed to allow for the natural deterioration of the furniture and furnishings.

If, however, you yourself pay certain bills, such as council tax (bills normally paid by the tenant), you must deduct this amount from the rent before you calculate the 10% wear-and-tear allowance.

You can choose instead (not as well!) to claim for the replacement cost of any individual item (e.g. a carpet). Note, however, that it is the replacement cost that must be claimed. If you have sold the old sofa, you will have to deduct the price you got for it from the cost of the new one. This is the replacement cost.

In most cases, using the 10% wear-and-tear allowance is far simpler and a great deal more cost effective.

LEGAL AND PROFESSIONAL FEES

You may decide you need a solicitor to draw up a lease or to take legal action to remove a tenant. These costs are allowable. Similarly, an agent’s fees for managing a property and an accountant’s fees for drawing up accounts are tax deductible.

SERVICES PROVIDED

You may decide to provide services for your tenants that have a direct cost implication for yourself. These could include, for example, gardening costs or the cost of cleaning or the cost of communal heating. If you pay any of these costs, you can set them against rental income, so long as they are wholly and exclusively for the purpose of letting.

ENERGY SAVING ALLOWANCE

Some might say about time too! At last an incentive for landlords to conserve energy. The incentive centres around two forms of heat insulation – loft and cavity wall. The cost of installing these is tax deductible. Each tax year, however, an upper limit is set for the total cost allowable for these works in any one building. Check the Inland Revenue Helpline for the current limit.

ONGOING BILLS

By virtue of owning the property (whether it is let or not) the landlord has ongoing bills to pay:

• The property must be insured. The cost of buildings and contents cover is allowable. Also allowed is the cost of a rental guarantee policy, designed to compensate the landlord for the loss of rent. If a claim on such a policy has been met, however, the amount received under the claim must be declared as income. The cost of personal policies (such as life and critical illness policies) is not allowable.
• If the property is leasehold, there will normally be ground rent to pay to the freeholder. This is tax deductible.
• The tenant would normally pay council tax but, if the landlord pays this, the cost is allowable.
• If the landlord pays the water rates, the cost is allowable.

OTHER EXPENSES

There will always be other miscellaneous costs. If these are incurred wholly and exclusively in connection with the rental business, they will be allowable. Examples are as follows:

• Advertising for tenants.
• Travelling (car or public transport).
• Stationery and postage.
• Telephone calls.
• Costs incurred in collecting rent.

Proper records and receipts should be kept.

RENT-A-ROOM EXEMPTION

This scheme is intended to benefit the homeowner who lets out a room in his only or main home. It does not include the following:

• A room let in your holiday home in the west of Ireland!
• A room let as an office.
• A room let in the course of a bed-and-breakfast or guest-house business.
• A room let while you are living abroad.
• A room let in your own home while you occupy accommodation provided by your employer.

It is clear that the scope of the exemption is narrowly drawn, but it is valuable, none the less. If the letting qualifies under the scheme, the rent received is free of tax. All you have to do is tick the appropriate box on your tax return.

As always, there is a limit to the Chancellor’s generosity. A cap is placed on the rental income that is free of tax. Rent above this figure is not exempt. The cap is currently £4,250 (this figure is the gross rent, i.e. before allowing for any expenses). To put this in perspective, a 40% taxpayer would have to earn £7,083.33 to achieve (after tax) the same income. It is subject to change (it was set at this figure in the 1997/8 tax year) and, who knows, might be increased one day. Check the Inland Revenue helpline for the up-to-date figure.

If you receive rent in excess of the limit, you can choose how this excess amount is taxed. There are two options:

• Allow the excess to be taxed without the benefit of any relief for expenses, etc. You can claim nothing for the costs incurred by your lodger.
• Don’t use the rent-a-room exemption at all and add the rent received to other rental income in the normal way, thus making use of all available reliefs.

Always remember you can opt out of the rent-a-room scheme altogether if you have incurred losses as a result of the scheme and wish to offset these losses against other rental income. This should be made clear in your next tax return.

There would normally be no council tax implications as a result of the scheme. But if your tenant happens to be a full-time student, there may be benefits for yourself. As full-time students do not pay council tax, you may qualify for a 25% council tax reduction as a result of your new lodger. Contact your local council.

A further, important consideration is the question of CGT on the sale of the property concerned. Despite the income earned from the rent-a-room scheme, there is no CGT liability on the sale of the property. It continues to benefit from full principal private residence exemption.

Finally, a few points to note if there is a mortgage on the property. Strictly speaking, the lender should be informed beforehand and must give permission for the letting. Secondly, a lender will not normally accept the rental income when calculating how much they are prepared to lend on the property.

PERSONAL ALLOWANCE

Lastly, having reduced your taxable rental income by making use of all available reliefs and exemptions, don’t forget to apply your personal tax allowance. Each tax year we are given an individual tax allowance which can be set against our income (£5,225 for 07/08). If you have taxable income in addition to rental income, the allowance should be set against the total figure.