Properties Let ‘Cheaply’ – What are the Tax Implications?

The average rental paid for a privately let residential property in England and Wales currently stands at £153.59 per week. The website Zoopla shows the highest rent of a single property as £60,000 per week and the lowest at £21 per week. Despite the disparity these figures are for properties let at a commercial rent and do not take into account the many properties that are let at an uncommercial or even what is termed ‘peppercorn’ rent. Some important tax implications are outlined below.

Income tax

• ‘Peppercorn’ rent – What is it?

A ‘peppercorn’ rent is not rent in the strict sense of the word; rather it is the payment of a small amount (usually £1 per year) in conjunction with a (potentially substantial) premium paid for a lease. It is often paid as ground rent on a long lease of usually of 99 or 125 years (deemed a ‘virtual freehold’).

In practice, a ‘peppercorn’ rent is not demanded although occasionally a pedantic legal conveyancer may require the collective arrears to be included as part of the financial statement on completion of the lease sale. The reason for the inclusion in the contract is to maintain a formal landlord/ tenant relationship, so that there is no risk of the tenant (being the purchaser of the lease) claiming ‘squatters rights’ which could technically be possible if no consideration was paid for an extended period.

• Uncommercial rent

Properties rented at an ‘uncommercial’ rent are something very different - there is no transfer of ownership. Such properties are let at a reduced rent or sometimes for no rent at all (for example to relatives). The definition of an ‘uncommercial’ let is a property rented for less than the market rate of a comparable property in the neighbourhood.

HM Revenue and Customs (HMRC) do not have the power to tell a landlord how much to charge for the rental of their property, however, they can restrict the amount of expenses claimed against the rent that is paid. HMRC 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’ which is what is required to arrive at rental business profits (seewww.hmrc.gov.uk/manuals/pimmanual/PIM2010.htm).

However, HMRC are prepared to allow expenses to be deducted up to the amount of rent received, thereby producing neither a profit nor a loss; which might be read as being a good thing until it is appreciated that it also means that any excess expenses cannot be carried forward for deduction against rental income received in a later tax year. Losses incurred on such a property simply do not exist - it is not that the losses cannot be offset (whether against income on the same property or against income from other properties in the rental business), rather that they are not allowed to arise in the first place.

• ‘Rent free’

The position is completely different if the property is let out rent-free. HMRC regard such properties to be tax neutral and therefore outside the scope of the property income tax regime. To be within the regime, there must be a source of income but there is no source of income if no rent is charged and as the property is then not within the property tax regime, there is no associated deduction for expenses. This means that any expenses that are incurred in relation to a property let out ‘rent free’ are lost and cannot be relieved.

Income Tax pitfalls

Allowing friends and family to live in a property rent free might be a kind gesture but doing so may affect the extent to which expenses are deducted. If a property is not available to generate income, the expenses will not have been incurred ‘wholly and exclusively’ for the purposes of a property rental business. To ensure that the property does not lose its ‘business’ status it needs to remain available for commercial letting at all times even if the property is being used rent-free for a time.

Problems may also arise when considering the deduction of expenses during periods when the property is lived in by ‘house sitters’ who do not make any payment whilst staying at the property.

However, provided the property is usually available for commercial rent and the owner can prove that he is actively looking for tenants, any expenses incurred will be allowable. No hard and fast rules exist to say how much ‘house sitting’ time is allowed, but tax inspectors have given guidance suggesting that this should not add up to more than a month in any three year period (seewww.hmrc.gov.uk/manuals/pimmanual/PIM2220.htm).

If the property is usually let as a holiday let and the owners allow friends to stay ‘rent free’ or at a discounted rate then the ‘uncommercial’ letting rules apply for that period.

If rooms are let in the owner’s residence, then so long as the total rent received in any tax year is less than the ‘rent a room’ limit of £4,250 no tax will be due. It does not matter whether the amount received is levied at a commercial or non-commercial rate - HMRC will not enquire. If the rent does exceed this limit the excess will be taxed but this ‘excess’ amount may be covered by the landlord’s tax-free personal allowance.

VAT - a couple of points of relevance:

• If property is let out by a business registered for VAT and the amount received is less than the market rent, then any VAT charged is normally only on the actual amount paid. However, if the parties are connected, HMRC may direct that VAT is to be accounted for by using the market value (VATA 1994, Sch 6, para 1).

• In a VAT case (Riverside Sports and Leisure Ltd [2009] 1 EGLR 75) a school had leased a sports centre to an operating company at a ‘peppercorn’ rent. The school was allowed to use the leisure centre but only at certain times, which the appellant otherwise exploited commercially. No money changed hands but arrangements had been effected in such a manner that it meant that the operator was supplying the facilities back to the school out of its lease. HMRC raised various tax assessments treating the transaction as a barter of taxable services by the appellant in return for the VAT-exempt grant of a lease by the school. The appellant argued that there was no charge to VAT as there was no supply of leisure centre facilities back to the school; the school had retained its rights to the leisure centre under the demise of the lease. The VAT Tribunal disagreed and found for HMRC. 

Stamp duty land tax (SDLT)

If a purchaser buys a new lease paying a premium and a nominal/peppercorn rent SDLT is calculated on the amount of premium only and this applies whether the lease is for a residential or non-residential lease. Thus SDLT is calculated using the same method as for the purchase of a freehold property.

And finally - capital gains tax (CGT)

When a property let at an uncommercial rent is sold the CGT pages of the landlord’s personal tax return need to be completed. Provided that the property has been let as residential accommodation (regardless of the amount of rent or the connection with the tenant), and has at some time been the landlords main residence, then lettings relief will be due on any gain made.

Practical Tip :

Allowing someone to live in a property rent free or at a less than commercial rent can cause all kinds of tax problems. Most importantly, the property needs to remain available for commercial letting at all times and to ensure full tax relief on expenses incurred try to plan payments such that the amount equals the amount of rent received per tax year.

This is a sample article from the monthly Property Tax Insider magazine. Go here to get your first free issue of Property Tax Insider.