Offset Rental Losses
Tax Concessions for Property Investors
MANY PROPERTY investors make rental losses. In other words, their rental income does not cover their costs, especially when there is a mortgage involved.
Unfortunately, a rental loss cannot generally be offset against your other taxable income, for example your salary or profits from another business.
Most rental losses have to be carried forwarded until you start making rental profits.
There is, however, one important exception to this rule which allows you to start saving tax immediately:
If you have rental losses and have spent money on items that qualify for capital allowances, some or all of your losses can be offset against your other income.
What are capital allowances? When you buy certain qualifying assets for your business (including your property rental business), a percentage of the cost is allowed as a tax deduction each year. Sometimes 100% tax relief is allowed in the year of purchase, thanks to the annual investment allowance.
I will explain exactly what types of capital allowances can be claimed by property investors shortly. First of all, let’s take a look at some examples showing the potential tax savings:
Rannia is a self-employed graphic designer and has a portfolio of rental properties. Her property expenses exceed her rental income, producing a rental loss of £10,000 in the current tax year. Included in her property expenses are capital allowances of £15,000. Rannia can offset £10,000 of her capital allowances against the profits from her graphic design business. If she is a higher-rate taxpayer this will save her £4,000 (£10,000 x 40%).
Kathy is employed as a buyer for a big clothing company and also has a portfolio of rental properties. During the current tax year she incurs a rental loss of £10,000. Her capital allowances for the year come to £3,000. Kathy can offset £3,000 of her capital allowances against her salary. If she is a higher-rate taxpayer this will save her £1,200 (£3,000 x 40%).
So exactly how much can be offset against your other non-property income? From the above examples you may have figured out that you can offset an amount equal to the lower of:
- Your capital allowances for the year, or
- Your rental losses for the year
The offset reduces your total taxable income for the year, saving Income Tax at 40% for most higher-rate taxpayers, or even 50% for those with income over £150,000. There is no National Insurance saving, however, as this is unaffected by this type of loss relief.
What capital allowances can property investors claim?
First of all, it is important to point out that you cannot generally claim tax relief for the building itself. A reader emailed us with this question a few weeks ago, so it’s worth clearing up.
The only exception to this rule is so-called ‘industrial property’ which currently attracts capital allowances at just 1%. Even this paltry allowance will be abolished next April.
So, if you cannot claim capital allowances for the properties themselves, this leaves:
- Assets inside the rental properties (e.g. furniture and appliances)
- Assets used to manage your property business (e.g. cars and computers)
Assets Inside the Properties
Most residential property investors claim an annual wear and tear allowance.
Instead of claiming the actual cost of furniture, appliances and other equipment in your rental properties, the wear and tear allowance allows you to claim an annual tax deduction which is generally 10% of your rental income.
This is quite a generous tax deduction BUT it is not a ‘capital allowance’, even though it does the same job.
This means your wear and tear allowance cannot be offset against your other income if you have rental losses.
Residential property investors can, as an alternative to the wear and tear allowance, claim the cost of replacement furniture, equipment, etc – the so-called renewals basis. Again, this type of spending is not a capital allowance.
The landlord’s energy-saving allowance is also not a capital allowance for these purposes.
There are, however, two types of rental property that do qualify for capital allowances on assets within the property:
- Furnished holiday lets
- Commercial properties
Commercial property landlords can offset their capital allowances against their other non-property income to the extent they have rental losses.
Owners of furnished holiday lets can do the same but, currently, can alternatively set all their rental losses from these properties against their other income of the same year or the previous year. This latter relief is under review, however, and may be curtailed somewhat from next year.
The standard capital allowance rate is 20%, but there is a special annual investment allowance which currently provides immediate 100% tax relief for the first £100,000 of spending on qualifying items, such as:
- Furniture, white goods, sinks, baths, and showers
- Storage equipment, display equipment, counters and checkouts, refrigeration equipment
- Computers, telecom equipment and TVs
- Fire and burglar alarms and surveillance systems
- Moveable partitioning
- Advertising hoardings, signs and displays
- Integral features
‘Integral features’ include all the wiring, lighting, plumbing, heating and air conditioning in any commercial property or furnished holiday let.
Coupled with the annual investment allowance, this means that when you buy a commercial property or furnished holiday let, you can claim immediate 100% tax relief of up to £100,000 for all the existing wiring, plumbing and other integral features.
This is as close as you can get to claiming tax relief for the building itself.
Daniela, a self-employed management consultant, earns fees of £200,000 per year advising Government departments how to save money. She is also a keen property investor. She buys a High Street shop at auction. The existing wiring, lighting, plumbing, heating and air conditioning inside the property are valued at £15,000. The entire amount qualifies for the annual investment allowance. She has rental losses for the tax year of £20,000. This means her entire capital allowance claim of £15,000 can be offset against her other income, producing a saving of £7,500 (£15,000 x 50%)
Assets Used to Manage the Business
All property investors, including all residential property investors, can claim capital allowances when they spend money on qualifying assets used to manage their properties, including:
- Furniture (e.g. in a home office)
Most of this spending will qualify for the 100% annual investment allowance, including purchases of vans (remember that double cab pickups are treated as ‘vans’).
If you buy a car, you will generally only qualify for capital allowances of 10% or 20%, depending on the car’s CO2 emissions.
If the asset is also used for private purposes then you must reduce your capital allowance claim accordingly (cars are almost always used privately and the taxman would be very suspicious of any claim for 100% business use).
Aileen owns a portfolio of buy-to-let flats and is employed as the entertainment officer at a recently nationalised bank. She buys a new laptop for £1,000 which is used exclusively to manage her portfolio. She also buys a new table and chair for her home office, costing £400. Both items qualify for the annual investment allowance.
Finally she buys a car for £20,000 and uses it 40% for her property business and 60% privately. The car has CO2 emissions of less than 160g/km and attracts capital allowances of 20%.
In the current tax year, Aileen claims a capital allowance of £1,600 on her car (£20,000 x 20% x 40%).
Her total capital allowance claim is £3,000 (£1,000 + £400 + £1,600). Let’s say Aileen has a rental loss for the year of £4,000. This means her entire capital allowances of £3,000 can be offset against her salary, saving her £1,200 in income tax if she is a higher-rate taxpayer.
Repairs v Capital
It is important to note that capital allowances are only available on capital expenditure, so none of the issues discussed above have any impact on the treatment of repairs expenditure, including the replacement of fixtures such as sinks and baths in properties which you have already been renting out. For a full examination of the ‘repairs v capital’ question see the August 2009 issue of Business Tax Saver.
Owners of furnished holiday lets and commercial properties can claim capital allowances when they spend money on assets inside their properties. All property investors can claim capital allowances when they buy assets used to manage their businesses (e.g. computers and vehicles). A few investors can also claim additional capital allowances on renovation and conversion costs in certain special cases.
If you have also incurred rental losses for the year then you can claim some or all of your capital allowances as an income tax deduction against your other non-property income either this year or next. The amount you can claim is generally the lesser of your capital allowances and your rental losses. Furnished holiday letting landlords can alternatively set all their rental losses against other income of the same year or the previous year.
Where relief is available for the capital allowances element within your rental losses, you can claim to make the offset against your other income in either the same tax year as the rental loss arises, or in the following tax year.
Generally, it makes sense to obtain relief sooner rather than later, so most of the time property investors will prefer to claim relief in the year that the loss arises.
In some cases, however, it may be better to claim relief in the following year. For example, you may be a basic rate taxpayer this year but a higher-rate taxpayer next year. In this case, you would double the value of the relief (from 20% to 40%) if you made your claim against next year’s income instead of this year’s.
Brian is a self-employed builder and also owns several rental properties. He made trading profits from his building business of £40,000 in 2009/10 and £60,000 in 2010/11.
In 2009/10, Brian claimed capital allowances of £25,000 in his rental business which resulted in him having an overall rental loss of £12,000.
Brian could set his rental loss off against his 2009/10 trading profit, but this would only provide tax relief at 20%, i.e. £2,400.
Instead, therefore, Brian claims to set his 2009/10 rental loss against his 2010/11 trading profit. This produces twice as much saving: £4,800 (£12,000 x 40%), so it is well worth waiting an extra year for the relief!
Note that it does not matter if Brian makes a rental profit in 2010/11, he can still claim relief for the previous year’s rental loss against his other income that year.
Property investors can choose whether to claim relief against this year’s income or next year’s, but they cannot split their claim between both years.
For example, if Brian had made a trading profit of £50,000 in both years, he would have liked to claim £6,000 of relief each year, so that he obtained relief at 40% on the whole loss. Sadly, he cannot do this: he must simply choose which year to make the claim.
If, however, the allowable loss exceeds their total income for one year, the investor can make a claim against both years’ income and can specify the order in which the claims are to be made in order to produce the best result.
It is also not possible for investors to restrict the amount of their loss relief claim in order to preserve enough taxable income to utilise their basic rate tax band or their personal allowance. Once a claim is made, the whole of the amount eligible for relief must be deducted from the relevant year’s taxable income.
Investors can, however, sometimes produce the same result by restricting their capital allowances claim in the first place. Capital allowances are not usually mandatory and any sum between zero and the full allowance available may be claimed in most cases.
Where anything less than the full allowance is claimed, we call it a ‘disclaimer’. A disclaimer will lead to greater capital allowances being available in future, but the future relief will be at a much lower rate, so this is usually only worth contemplating where the disclaimer enables the investor to utilise their personal allowance.
There are two special cases where property investors may be able to claim additional capital allowances on conversion or renovation expenditure.
Firstly, for residential property investors, there is the ‘flat conversion allowance’. Broadly speaking, this provides tax relief for expenditure incurred on flats above shops and other business premises built before 1980, which are currently vacant or merely used for storage purposes, in order to bring them back into residential occupation.
For commercial property investors, the ‘business premises renovation allowance’ provides a similar relief for expenditure incurred in bringing vacant property within certain designated ‘assisted areas’ back into business use.
Both allowances provide immediate 100% relief for all qualifying expenditure and are not subject to any limit. Alternatively, the investor may claim relief of up to 25% per year.
Each allowance is subject to numerous qualifying conditions, so they are not as widely available as it may initially appear. Nevertheless, under the right circumstances, property investors may be able to use these allowances to get tax relief against non-property income and produce savings equal to up to 50% of their expenditure.