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 which squeeze rental profits. The previously generous "wear and tear allowance" for computing how much can be deducted from rental profits to represent the costs of furnishing has been replaced by a more stingy "replacement allowance".
Most recently the government has introduced a rule restricting the deductibility of finance costs when working out the rental income on which tax is paid.
Furnished Holiday Lets (FHLs) have as a rule escaped the government's recent anti-landlord ire 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 one which should certainly be explored.
What is an FHL?
The rules give a number of conditions which must be satisfied in respect of a given property for it to qualify as FHLs for tax purposes. These are as follows:
- The property needs to be furnished.
- The property must be situated in the UK or any other state in the European Economic Area (EEA).
- The property must be available for letting as holiday accommodation to the public for at least 210 days in the year.
- Out of those 210 days the property must actually be let out for 105 days or more as holiday accommodation. If you have multiple properties there is an "averaging election" which can be made in certain circumstances which can help satisfy this condition where some properties are let out for fewer than 105 days.
As a rule, if a property is let for a continuous period of more than 31 days then this will not qualify as "letting as holiday accommodation".
The above conditions must be satisfied year on year. A property could qualify as an FHL for one year but fail to qualify in the next year. Therefore, landlords should monitor carefully the length of stays of guests etc. to ensure the conditions continue to be satisfied.
FHL Tax Advantages
The tax advantages attaching to FHLs take various forms and touch on a range of issues.
Income Tax – Finance Costs
George Osborne announced in the Summer Budget 2015 the introduction of new rules to restrict the deductibility of finance costs when computing the tax payable on the rental income of residential property in the UK. Previously it was the case that all interest payable on loans taken out to purchase a rental property could be deducted from the rent for tax purposes. The new rules (which are coming into force gradually) mean that by the tax year 2020/21 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 major increase in yearly income tax payable.
These changes do not apply however to FHLs. For those landlords who have taken on a significant amount of debt it may be worthwhile considering whether it is feasible to have their investment property reclassified as an FHL in order to sidestep the new rules.
Interests in FHL businesses will be exempt from IHT on the death of the owner, or life time 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. Please note that, unlike all the other tax advantages listed in this article, strictly speaking the conditions listed 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 have recently been attacking 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 that is not the case.
To qualify for BPR, FHLs need to show that they are providing substantial additional services over and above the normal active management of the property necessary to maintain or enhance the capital value or to obtain a regular income from its letting. To do this they need to consider whether the nature and purpose of the services taken together could be regarded as something that had a purpose beyond investment rather than just being incidental to the investment activity. Such supporting activities could include ongoing assistance with the holiday experience, booking restaurants and activities and providing advice on 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 there is an active trading business where it consists of a diverse range of activities/services and in general the closer the services provided are to those that you would expect to be provided by a hotel the more likely the owner is to be exempt from IHT on their FHL business.
Capital Taxes - Gift relief
Gift relief enables a tax payer to pass on their assets to the next generation without triggering a disposal for capital gains tax purposes (and paying Capital Gains on any gains). Instead the recipient inherits the base cost of the asset which the donor had.
There are general requirements for assets to be eligible for gift relief. Investment property does not qualify as a rule for gift relief, however FHLs do. In the context of succession planning FHLs can be useful enabling the taxpayer to pass wealth down to the next generation without triggering an immediate tax charge.
Capital Taxes - Entrepreneurs Relief
Gains accruing on the sale of residential property ordinarily attract Capital Gains Tax at 28% (or 18% 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 Entrepreneur's Relief ("ER"). This means that the level of CGT payable can potentially be reduced from 28% to 10%, provided the other necessary conditions are satisfied.
This differs from the taxation of the sale proceeds from ordinary investment property which as a rule cannot qualify for ER. Please note that only gains accruing to the property while it qualifies as an FHL can enjoy ER.
Profits made from FHLs are treated as Earned Income for tax purposes. This is important if the landlord wishes 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 as a rule and more work for a landlord than letting out a simple investment property. By virtue of the short stays, there is a greater interaction with holiday makers than with ordinary long term tenants and there will be a greater requirement to market the property in order to attract holiday makers. 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 described above it is something well worth keeping in mind for the future particularly if finance costs play a major part in the finance arrangements of the property portfolio.