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Landlords face challenges with new cash basis

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7th Mar 2017
Tax Writer Taxwriter Ltd
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Individual landlords will need to keep their accounting records on a cash basis from 6 April, and potentially suffer an additional interest restriction.

New cash basis

Since 6 April 2013 many unincorporated trading businesses have elected to use the cash basis when recording accounting transactions. Property letting businesses are not considered to be trading, so they have been barred from using the cash basis for their accounts. In practice, many landlords have kept their accounting records using a form of cash basis, but this deviation from GAAP has been overlooked by HMRC. 

This all changes from 6 April 2017, when a special version of the cash basis is introduced for individual landlords, which has special rules for the deduction of interest and finance charges. New rules also apply to the cash basis for trading businesses. I explained these changes in the expert guide to the cash basis and taxation.   

Opt out

The big difference for landlords, is that where their annual turnover (calculated on the cash basis) is no more than £150,000, the default accounting method will be the cash basis. The landlord can opt out of the cash basis and use GAAP accounting, by making an election on his or her tax return. However, this election will only take the landlord out of the cash basis for one tax year.

This will be confusing for many taxpayers, as they need to opt in to use the cash basis for trading businesses, and opt out of the cash basis for a property business. Where the landlord has separate property businesses, such as one letting UK properties, and another letting overseas properties, he can opt out of the cash basis for one property business and not for the other one. 

Thresholds

Unlike the cash basis for trading businesses, the cash basis for property businesses has no separate exit turnover threshold. As the law is currently drafted, a landlord will be within the cash basis if his turnover (gross rents) does not exceed £150,000, but an annual turnover of £150,001 will take him out of the cash basis for that year. This flaw in the draft legislation may be corrected before the Finance Bill 2017 is passed.

Jointly held property

Where a property business is jointly owned by individuals who are not married to each other, each individual owner can independently decide whether to opt out of using the cash basis or not. When one owner stays in the cash basis, another opts out, the accounts for the property business will have to be drawn up twice - once using GAAP accounting and also using the cash basis of accounting.  

However, where the property business is owned by a married couple or civil partners, both individuals must either use the cash basis, or GAAP accounting for their property income. This is presumably to prevent manipulation of profits from the lettings business between connected individuals.

Partnerships can use the cash basis for a property business, but only where all the partners are individuals. LLPs, companies, trustees and personal representatives are not permitted to use the cash basis for property businesses.  

Interest restriction

When using the cash basis for a trade, the amount of loan interest which may be set against income in one year is capped at £500. This cap doesn’t apply for a property letting business, but a different restriction is applied where the value of the loans outstanding (L) exceeds the value of the let properties (V) at the end of the tax year.

  • L = the business portion of all loans, so where a loan is partially used for a private purpose, only the business portion of loan capital is considered
  • V = market value of the properties when first let, plus the cost of any capital improvements, which have not been deducted when calculating the profits of the business  

The allowable costs of the loan are reduced by the fraction: V / L. This reduction applies before any reduction of finance costs relating to letting of residential property which applies from 6 April 2017, as I described in Huge tax bills ahead for landlords.

Example

Harry lives in England and lets five let residential properties which were worth £500,000 (V) when he first let them. There have been no improvements added since that date. The outstanding loans connected to his property business total £525,000 (L). He has finance costs of £42,000 in 2017/18 and rental income of £80,000. If Harry uses the cash basis for his property business in 2017/18 the deduction for loan interest is restricted using the fraction: V/ L as follows:

500,000    x 42,000 = £40,000

525,000

As Harry’s properties are residential, he must also restrict his finance costs by 25% in 2017/18, which means he can only deduct finance costs including interest of £30,000 (75% x 40,000).

The income tax payable on his property business for 2017/18 is calculated as:

 

 £

Tax £

Rental income:

80,000

 

Interest deduction:

(30,000)

 

Net income:

50,000

 

Less personal allowance

(11,500)

 

 

38,500

 

Tax charged at 20% on

33,500

6,700

Tax charged at 40% on

5,000

2,000

 

 

8,700

Tax credit on blocked interest at 20%

10,000

(2,000)

Total tax payable

 

6,700

Replies (4)

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By ireallyshouldknowthisbut
07th Mar 2017 18:14

Rebecca,

that costs restriction on mortgage interest seems to be virtually identical to the current rules for the accruals basis. ie draw up a balance sheet of the business and only give relief interest up to the capital employed by the business.

This doesn't seem to be an "additional restriction" as you note in the opening para.

Albeit this is seemingly ignored by many of the landlords returns we pick up from other accountants.

What is more 'interesting' is the treatment of finance costs added to the loan balance. This is not 'cash' paid. Similarly, deposits.

Thanks (1)
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By Mark Ferbert
08th Mar 2017 09:11

So how does any transition from an accruals basis to a cash basis apply in 2017/18 (or each year, if gross rental income fluctuates around the cut-off point)?
I'd imagine for landlords of commercial property with rents falling due in advance on the quarter dates, then the previous accounting treatment would have been to treat a large proportion of the rent due on 25th March as being in advance relating to next year. Under the cash basis, there would be no adjustment at the end of 2017/18 so those rents would be treated as income in 2017/18, but how do we deal with the amount in advance brought forward? It's not a cash receipt in 2017/18 so does it just fall out of account entirely?

On a similar issue, has anyone determined the best way to deal with mixed use property under the new rules for restricting loan interest relief. For example, a building is purchased for £250k with a loan of say £200k. The ground floor of the building is used as a shop (ie a commercial let) but the two floors above are split into flats which are let as residential lets. Rental income is say £20k p.a. from the shop and £5k for the flats. Interest of £5k is paid on the loan. Should there be a restriction in respect of the loan interest under the new rules, and if so, how would you calculate it?

Thanks (0)
Replying to Mark Ferbert:
By Brian Ogilvie
21st Sep 2017 12:51

Mark

Your point re accruals to cash at 6 April 2017 is a good one and little covered.

Sadly(!) I do not think it falls out of account .....

New Section 329A ITTAOIA 2005 states that 'adjustment income' applies to property businesses using the cash basis when they transition into calculating profits on the cash basis from GAAP or vice versa.

As I see it,this must include 2016/17

The section requires the spreading of any adjustment income over 6 tax years whilst section 239B allows an election to bring an additional amount into charge in a
tax year than would otherwise be brought in under the section 239A spreading rule

So in the case of your rent received in March 2017,nearly all of it would fall to be taxed between 2017/18 and 2023/24 as adjustment income unless you choose to accelerate this into one or more of these years

Alternatively opt for accruals accounting and none of the above applies !

Thanks (0)
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By rockallj
14th Mar 2017 00:22

And under mandatory MTD, the 'magic' free software will be able to take all this into account, huh?

Thanks (1)