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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:
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 1st January 2004 till 31st December 2004. She receives this on an annual basis.
This means that she receives £6,000 in rental income on 1st January 2004 and £6,000 on 1st July 2004. The 1st January 2004 rental income covers the period 1st January to 30th June and the 1st July 2004 rental income covers 1st July to 31st 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.
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:
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 1st January 2004 lies in this tax year.
2004-2005 tax year rental income is also £6,000. This is because the second payment of 1st July 2004 lies in this tax year.
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 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:
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 1st January 2004 was to cover the period 1st January to 30th 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 1st January to 5th April will be recorded against the 2003-2004 tax year and the income attributable from 6th April to 20th June to the 2004-2005 tax year.
Here is how the apportionment could be done:
Daily Rental Income
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 1st January to 5th 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 6th April to 30th 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 1st July is also attributed to the 2004-2005 tax year. This is because it covers the period 1st July to 31st December. This entire period sits within the 2004-2005 tax year.
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.
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.