Landlords of residential property in the UK could be forgiven for feeling painfully targeted by the government in recent years. Several tax changes have been introduced in order to squeeze rental profits.
The previously generous wear and tear allowance, used when computing how much can be deducted from rental profits to represent the costs of furnishings, has been replaced by a more stingy allowance. Most recently, the government introduced a rule restricting the deductibility of finance costs when working out the rental income on which tax is paid.
However, furnished holiday lets (FHLs) have generally escaped the government’s recent anti-landlord sentiment and come with other valuable tax advantages. Where the prospect of renting out a property to holiday-makers on short-term lets is realistic, the idea of acquiring an FHL is worthwhile exploring.
So, what is an FHL? The rules give a number of conditions that must be satisfied to qualify for tax purposes. These are simplistic, but must be accounted for and could be difficult to achieve.The property must be furnished, situated within the UK and European Economic Area, be available to let for 210 days a years and actually let for 50 per cent of that period. However, if a house or flat is let for a continuous period of more than 31 days, this will not qualify as letting it as holiday accommodation.
These conditions must be satisfied year-on-year. A property could qualify as an FHL for one year but fail to qualify the next year, so landlords should monitor guests’ length of stays to ensure the conditions continue to be met.
Key points
- FHLs have generally escaped the government’s recent anti-landlord sentiment.
- Interests in FHL businesses can be exempt from IHT on the death of the owner.
- Gift relief enables a tax payer to pass on their assets to the next generation.
The tax advantages for FHLs take various forms and touch on a range of issues. In the Summer Budget of 2015, then-chancellor George Osborne announced the introduction of rules to restrict the deductibility of finance costs when computing the tax payable on the rental income of residential property inthe UK.
Previously, all interest payable on loans taken out to buy a rental property could be deducted from the rent for tax purposes. The new rules, which are gradually coming into force, mean that by the tax year 2020-2021 the landlord will only enjoy basic rate income tax relief on their interest costs. For those property owners who have taken out considerable debt to build up their property portfolio, this change is likely to trigger a big increase in yearly income tax payable.
However, these changes do not apply to FHLs. Landlords who have taken on a substantial amount of debt might find it worthwhile having their investment property reclassified as an FHL in order to sidestep the new rules.
Inheritance tax
Interests in FHL businesses will be exempt from IHT on the death of the owner – or lifetime transfer of the interest – if business property relief (BPR) is available. FHLs will only qualify for BPR if the business is predominantly a trading business.
However, unlike all the other tax advantages mentioned, strictly speaking the conditions mentioned above do not need to be satisfied for such a property business to qualify for BPR. Rather, the onus is simply on the business activity being trading rather than investing. HMRC has recently been targeting FHL businesses on these grounds, so careful planning needs to be done to be as sure as possible that BPR does in fact apply.
If the business involves mainly making or holding investments, then it will not qualify and it is has become increasingly difficult to prove that this is not the case. To qualify, FHLs need to show they are providing substantial additional services over and above the normal or to obtain a regular income.
To do this they need to consider whether the nature and purpose of the services could be regarded as something that had a purpose beyond investment, rather than just being incidental. Such supporting activities could include ongoing assistance with the holiday experience, booking restaurants or other activities and providing suggestions for things to do in the area.
Each case will depend on its particular facts and so it is difficult to give definitive guidance as to when BPR will apply. However, it will be easier to prove that there is an active trading business where it consists of a diverse range of activities and services.
In general, the closer the services the owner offers are to those you would expect in a hotel, the more likely they are to be exempt from IHT on their FHL business.
Capital taxes – gift relief
Gift relief enables a taxpayer to pass on their assets to the next generation without triggering a disposal for capital gains tax. Instead, the recipient inherits the base cost of the asset the donor had.
There are general requirements for assets to be eligible for gift relief. Investment property does not usually qualify for gift relief, but FHLs do. In the context of succession planning, FHLs can enable the taxpayer to pass wealth to the next generation without triggering an immediate tax charge.
Entrepreneurs’ relief
Gains accruing on the sale of residential property ordinarily attract capital gains tax at 28 per cent, or 18 per cent for a small portion of gains where the seller is a basic rate taxpayer. However, gains on the sale of a qualifying FHL will qualify as business assets for the purposes of entrepreneurs’ relief (ER). This means the level of CGT payable can potentially be reduced from 28 per cent to10 per cent, provided the other conditions are satisfied.
Pension contributions
Profits made from FHLs are treated as earned income for tax purposes. This is important if the landlord wants to make pension contributions. In these circumstances, the amount a taxpayer can pay into his or her pension depends on the level of their earnings. This differs from profits on normal letting activities, which are not regarded as earnings for pension purposes.
Running an FHL requires more attention and more work for a landlord than letting a simple investment property. By virtue of the short stays, there is a greater interaction with holidaymakers than with ordinary long-term tenants and there will be a greater requirement to market the property in order to attract holidaymakers. It will, therefore, not always be appropriate or relevant to consider acquiring FHLs or switching a property from an ordinary investment property to an FHL.
However, given the tax advantages, it is something worth keeping in mind for the future, particularly if finance costs play a major part in the finance arrangements of the property portfolio.
Fiona Graham is a partner and Athel Hodge is an associate in the private client and tax team at Boodle Hatfield
