How to calculate your profits from your UK property rental income - by Arthur Weller and Amer Siddiq

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Most landlords (and even some accountants) are unaware that there are two methods that can be used to calculate your annual UK property income tax. These methods are known as ‘Cash Basis’ and ‘Earnings Basis’.

In this article we will explain when and how both methods can be used.

To demonstrate each of the methods the following case study will be used:

Case Study

Louise owns one buy-to-let property, which generate an annual rental income of £12,000. The rent is paid six months in advance and runs from 1^st January 2004 till 31^st December 2004. She receives this on an annual basis.

This means that she receives £6,000 in rental income on 1^st January 2004 and £6,000 on 1^st July 2004. The 1^st January 2004 rental income covers the period 1^st January to 30^th June and the 1^st July 2004 rental income covers 1^st July to 31^st December.

She also has some roof repairs carried out on the property in March 2004. The cost for the work done is £1,000. However the builder is a little slow in billing and he does not raise the invoice till May 2004, which Louise promptly pays.

Cash Basis

The cash basis can be used when the income generated from your property rental business (before allowable expenses are deducted) do not exceed £15,000 in the tax year.

When the cash basis is used, the income tax calculation is based on when the rent was actually received and when expenditures were paid. Note here that the emphasis in this method is on ‘received’ and ‘Paid’. In other words it is based on when money exchanges hands.

Lets see how the cash basis method will impact Louise’s profits:

Case Study

Louise completes her tax return using the ‘Cash Basis’ method

When she completes her tax return the rental income will attributed to the tax years as follows:

Rental Income Received

2003-2004 tax year rental income is £6,000. This is because the first payment of 1^st January 2004 lies in this tax year.

2004-2005 tax year rental income is also £6,000. This is because the second payment of 1^st July 2004 lies in this tax year.

Expenditure Incurred

The roof repair work was carried out in the 2003-2004 tax year, as it was carried out in March 2004. However the invoice was not paid till the following tax year. This means that Louise will only be able to offset the expenditure against the 2004-2005 tax year as this is when the invoice was paid and money exchanged hands i.e. May 2004.

Comments about the Cash Basis

The Inland Revenue gives the following conditions in paragraph 91 of the IR150 Manual.

We are, therefore, prepared to accept the use of a ‘cash basis’ (profits based on the cash paid and received in the year) provided all the following conditions are met:

the case is small; by a ‘small’ case we mean one where, for any year, the total gross receipts of your rental business (before allowable expenses are deducted) don’t exceed £15,000; and

the ‘cash basis’ is used consistently; and

the result is reasonable overall and does not differ substantially from the strict ‘earnings basis’

Earnings Basis

The earnings basis is also sometimes referred to as the ‘accruals basis’ and follows ordinary commercial accounting methods. When using this method there are two very important points to note:

Firstly – You can use this method regardless of whether the income generated from your property rental business (before allowable expenses are deducted) exceeds £15,000 in the tax year. In other words if your annual rental income is below £15,000 per year then you can still use this method. However if it is above £15,000 then you must use this method.

Secondly - The income tax calculation is based on the period in which the rental income arises and when expenditures were incurred. Note here that the emphasis in this method is on ‘arises’ and ‘incurred’ which is different to the cash basis method.

Lets continue with the case study:

Case Study

Louise completes her tax return using the ‘Earnings Basis’ method

When she completes her tax return the rental income will be attributed to the tax years as follows:

Rental Income Received

As we know, £6,000 was paid for the first six months that the tenant lived in the property. The upfront £6,000 payment on the 1^st January 2004 was to cover the period 1^st January to 30^th June. However, this payment covered both the 2003-2004 and 2004-2005 tax years.

(Please note: her for simplicity we are ignoring the fact that the year 2004 was a leap year)

Therefore the £6,000 rental income needs to be apportioned across both tax years, as the rental income attributable from 1^st January to 5^th April will be recorded against the 2003-2004 tax year and the income attributable from 6^th April to 20th June to the 2004-2005 tax year.

Here is how the apportionment could be done:

Daily Rental Income
£6,000 was due for 181 days (i.e. 1^st Jan to 30^th June).

This means that the amount charged per day = £6,000 / 181 = £33.15

Rental income for 2003-2004 tax year

The number of days from 1^st January to 5^th April inclusive = 95 days, and 95 * £33.15 = £3149.25.

Therefore £3,149 is attributable to and recorded against the 2003-2004 tax year.

Rental income for 2003-2004 tax year

The remaining rental income from 6^th April to 30^th June is attributed to the 2004-2005 tax year. This amount is £2,850.75.

Also, the entire rental income of £6,000 that is paid on 1^st July is also attributed to the 2004-2005 tax year. This is because it covers the period 1^st July to 31^st December. This entire period sits within the 2004-2005 tax year.

Expenditure Incurred

Even though the payment for the roof repair work was made in May 2004, the work was actually carried out in March 2004. This means that because March falls within 2003-2004 tax year the £1,000 cost will be attributed to this tax year.

As you can see it is beneficial to offset the cost in this tax year rather than waiting till the following tax year.

Comments about the Earnings Basis

Here are some important points to note when using this method.

This method must be used if your gross income exceeds £15,000 per tax year. However you can also decide to use it even if your income is less than £15,000.
In the case study we calculated the amount due for the five odd days in April. The Inland Revenue does allow a concession here to simplify the computation. The concession allows you to ignore the split if you do it consistently across both income and expenditures and the figures are small. The strict daily apportionment is required when the figures are ‘substantial’. Please note that there is no indication given by the ‘Inland Revenue’ as to what is meant by ‘substantial’.
As you have seen here we are not working on the basis of what was paid or received. Therefore if a tenant did not actually pay the rental income that was due then you would create a bad debt to offset this against the rental income.

Having your taxes calculated for you

Landlord’s Property Tax Manager software uses the ‘Earnings Basis’ method when calculating the profits and tax due on your existing portfolio. For more information about this unique piece of software please click here.

About Arthur Weller

Arthur Weller is a Chartered Tax Advisor (CTA) and an integral part of the Property Tax Portal team. He offers a special rate tax advisory service on any aspect of UK taxation, including property taxation, for as little as £87 for a 30 minute telephone tax consultation.

To learn more about this service click here.

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