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Property Investment: Advanced Principles
On-line content taken from the Provestor eBook presented in periodic serialized weekly format.
Terms and conditions - legal disclaimer.
Posted 3rd December 2007
Part Three
Tax & Tax Free Lump Sums
When running a traditional business, income received by a sole trader, a partnership or a company has to be declared to the Inland Revenue at the appropriate times, either by way of self declaration or by using a qualified accountant to prepare a set of accounts.
It is no different in regard to the property market, as rental income is classed as earned income.However, like traditional businesses there will be overheads to take into account, such as marketingexpenditure, telephone, travel, renovation costs, mortgage payments etc. (A list of allowableoverheads can be obtained from an accountancy firm or the Inland Revenue directly). Income tax isonly paid on net profits and if expenditure is equal to or more than the rental income, no income taxwill be due. However, you cannot base your property income in isolation of other income for incometax purposes unless operating your property portfolio as a Ltd Company.
Will I have to pay tax on my letting income?
Not necessarily - it all depends on your personal financial circumstances. For example, if the letproperty is mortgaged, and the mortgage and related costs of up-keeping the property exceed therent you receive, then it is possible that no tax will be payable.
Home letting - your tax position
Income tax is payable on rent received from property which is let. Your tax position will determinewhether you pay tax or not. All profit you make from letting should be added to your other taxableincome for the year, although the financial records for letting must still be kept separate.
You have to pay income tax if the total of your taxable income is greater than your tax allowances.
Rent a Room Scheme. If you let rooms within your own home, you may qualify for a tax exemption. Contact your tax office for more details. (Inland Revenue Booklet number 87)
What expenses can be offset against the rent received?
Only those expenses incurred "wholly and exclusively" for the purpose of the let can be offsetagainst your letting income. This leaflet explains many of these allowable expenses in a latersection. These might include mortgage interest, general repairs and maintenance, insurance and ofcourse your agent's property management fees.
What records do I need to keep?
You need to keep a record of all income and expenditure incurred in relation to all lettings. Therecords should show to whom payments have been made and from whom income has been received.
Forms of the type shown below can be used to compile your Letting Income Schedule.
Completing your income schedule
The example schedule below demonstrates how you may calculate your tax liability on income fromfurnished lettings.
For your guidance in completing your income schedule, the following brief notes will help you todecide what to include and what not to include:
WATER AND OTHER RATES.
Include here the full amount of water, sewerage and any otherrates paid on the property, if these are not paid by the tenants. In certain circumstances, a landlordmay also be liable for council tax and this could then be included.
INSURANCE.
You may include all insurance (buildings, contents and mortgage protection etc.)policies in connection with your property.
REPAIRS & MAINTENANCE.
This may include any expenses that are for repairs and generalmaintenance of the property. Costs for improvements to the property cannot be fully set off againsttax.
PROPERTY MANAGEMENT FEES.
On request, at the end of the tax year, your letting agentshould be able to provide you with details of your rental income and management fees.
WEAR & TEAR.
For property let furnished, you may claim an allowance for the wear and tear offurnishings. This is calculated by taking 10% of the rental income for the year, less water rates andcouncil tax (if paid by the tax payer). Alternatively, you can claim for replacement costs - but inmost cases, the 10% allowance is both more beneficial and simpler.
Things you should remember:
RECEIPTS.
Have you kept receipts for all expenses incurred? From 6 April 1996, all tax-payershave been required to keep tax records of all purchases and receipts under the self assessmentsystem. You are required to keep the records for five years.
CAPITAL GAINS TAX.
Should you sell your property, you may become liable for Capital GainsTax. Your tax advisor can explain this in greater detail.
Things you should consider:
Insurance schemes are now available to protect against rent arrears and costs of legal disputes withtenants.
In all cases a qualified tax practioner should be contactedto ensure compliance with the Inland Revenue.
Where do you go for more Information?
If you would like more information, you should try the following sources: Self-Assessment Ageneral guide - SA/BK1 A guide to keeping records - SA/BK3 Rooms to Let - Inland Revenue leafletIR87 These leaflets and other information are available through your local tax office. 'Which?' -Consumers' Association Tax Saving Guide. Published annually. Department of Environment LeafletNo. 22. Letting Rooms in Your Home. Available from the Citizen's Advice Bureau. Inland Revenue TaxHelpline: Tel: 0645 000444
Tax Free Income
Under current legislation you do not pay tax on borrowed money, and this is a fact that is one of the corner stones of building a property portfolio.
We described earlier the signs that pre-warn you of a market which is about to turn against you. Ifand when the property market drops like it did in the early nineties you may be tempted to sell yourproperties. Our advice however would be to hold on to them as long as the rental income coversyour borrowing.
As you build your property portfolio you may eventually within a few short years have sufficientresources to consider the business full time.
Let's assume that it takes you two months to complete each of your no money down deals. In 2 yearsyour property portfolio would then consist of 12 properties. If each of your properties had anaverage value upon completion of £100,000 then your portfolio would be valued at£1,200,000 - that is not taking into account the increase in equity on your First few purchasesduring the 2-year period. If property continues the way that it has over the last 10 years, (andmost statistics would support at least the same growth rate if not a lot higher) a 5% per annumincrease in property values would be considered very conservative.
Let's take a look therefore at your worth over the next few years
Year Portfolio Value %increase per year Increase
2006 £1,200,000 5% £0 2007 £1,263,157 5% £63,157
2008 £1,329,639 5% £66,482
2009 £1,399,620 5% £69,981
2010 £1,473,285 5% £73,665
2011 £1,550.826 5% £77,541
The increase column clearly shows that with just a conservative increase in property values overthe next few years you would have an income of over £60,000 TAX FREE by the end of 2007.(Assuming that borrowing is covered by the 130% rental yield). After that your income wouldincrease by around 5%.
So, how is this achieved?
As has previously been stated the art to receiving your income is in re-financing your properties.Your portfolio should generally always increase in value and therefore the equity in your propertiesshould increase. Re-financing your portfolio is done theoretically in exactly the same way as re-mortgaging your own home.
REMEMBER NO TAX IS PAYABLE ON BORROWED MONEY.
Example of Letting Income Schedule
| Rental Income for the year |
|
|
| Ended 6th April 2006 |
|
£4500 |
| |
|
|
| Expenditure |
|
|
| Water and Other Rates |
£210 |
£4500 |
| |
£210 |
|
| Rents (net of rates) |
|
£4290 |
| Insurance |
£190 |
|
| Repairs & Maintenance |
£310 |
|
| Motor Expenses |
£20 |
|
| Cleaning Materials |
£10 |
|
| Sundry Expenses (tel., post etc) |
£20 |
|
| Gardener’s Wages |
£50 |
|
| Other (carpet cleaning) |
£80 |
|
| ------------- |
£ |
|
| ------------ |
£ |
|
| Management Fees |
£500 |
|
| Accountancy Fees |
£50 |
|
| Wear & Tear |
|
|
| (allow 10% of rents net of sales) |
£429 |
£1659 |
| Net Rents |
|
£2631 |
| Less Interest Paid on mortgage Loan |
£1800 |
|
| Taxable Income |
|
£831 |
Capital Gains Tax
Capital Gains Tax in levied on the profit made by an individual on the disposal of certain assets.
In simple terms it can be distinguished from income tax because it relates to one off transactionsrather than a regular occurrence.
Some assets are exempt from liability, these include:
- Profit on the sale of a persons main residence
- Profit on the sale of Government Bonds (gilts) by an individual
- Profit on the sale of a private motor vehicle
- Betting winnings
- Gains made on life assurance policies where that gain is made by the owner of thatpolicy.
- Chattels with a predicted useful life of less than 50 years. (e.g. caravans and boats)
- Gains made on other chattels (movable assets such as a table or a clock) sold for less than £6000
In addition to the above examples an individual receives an annual exemption from capital gains tax. At the moment it is £8500.
Prior to the 1998/99 tax year it was accepted that part of the gain made on selling an asset mightbe due to the effects of inflation.
To allow for this, a system in indexation was used to increase the original acquisition price of theasset by the rate of increase in the Retail Price Index between the date of acquisition and disposal.This meant that the taxpayer would only be liable for capital gains tax on the real gain and not on theinflationary gain.
In April 1998 indexation was replaced by a new system of tapering capital gains tax.
This system means that in future, capital gains will be calculated of disposal price minus the actual acquisition price. (Or indexed value on the 5th April 1998 if acquired before that date.)
An allowance is them made, based on the number of years that the asset was held prior to disposal; the longer the asset has been held, up to 10 years, the lower the percentage of the gain that will be chargeable to tax.
For assets held in excess of 10 years from the 5th April 1998, there is no further reduction. (Refer to current tax tables for actual figures)
Taxable gains above the annual capital gains tax exemption are added to a person's income to determine the rate of tax applicable. The rate of capital gains tax levied on taxable gains will vary, but the minimum rate chargeable on any taxable gain is 20%.
Please Note: Some installments are quite short, while some are quite long like this third section, as the eBook does not divide into neat, equal chunks.
Check back in a week for the next installment - 'Theory'
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