How to use your allowances to minimise tax on rental income
For most investors, property is a long-term investment. According to a report by TotallyMoney.com, gross buy-to-let yields in the UK average 4.17%. In some areas, they are almost three times as high. Gross yields are calculated before tax on rental income and other costs are taken into consideration, so provide the best comparison with income of other investments.
When you compare buy-to-let yield with other investments, they more than hold their own:
- Shares in the FTSE 100 index yield an average of 4%, but capital growth has been virtually non-existent over the last 15 years.
- You can get as much as 5% on cash, but the TSB savings account only pays that rate for up to £2,000 of savings. And there is no prospect of capital growth.
- Residential property yields an average of 4.17%, and over the last 20 years, the average house price in the UK has increased from around £50,000 to around £200,000 today.
Some investors make money by buying and selling the property and making capital gains. When you invest in buy-to-let property as a long-term investment, your primary interest will be the income return.
In this article, I’m going to explain how the tax on rental income is charged. Once I’ve done this, I’ll show you how you can minimise tax on rental income as a married couple, thus effectively maximising buy-to-let yields.
How is the tax on rental income charged?
The amount of tax you’ll be charged on rental income depends on your rental profit and other income including wages and pensions. To calculate your rental profit, you first take away all your tax reducing deductibles (or allowable expenses) from your gross rental income. Allowable expenses include things like letting agent fees, and costs when making repairs to the property.
The way that mortgage interest relief is claimed is changing, so we’ll ignore it for ease of explanation of income tax liabilities here.
Let’s say you have rental income of £14,000 in 2015/16 and allowable tax deductibles (or expenses) of £2,500. Your rental profit is £11,500. Let’s also assume that you have paid employment, and earned £37,000 in the tax year.
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You add your rental income to your other income, and then calculate tax:
- Total income = £48,500
- Tax allowance = £10,600
- Taxable income = £37,900
- You pay 20% tax on taxable income up to £31,785 (£6,357), and 40% tax on the balance of £6,115 (£2,446).
Your total tax bill is £8,803 for the year, of which £5,280 is the tax on wages and £3,523 is the tax on rental income.
Make your marriage a real partnership and maximise your buy-to-let yield
Let’s say your spouse only earns £20,000 per year. By holding your property in joint names, you will split the rental profit 50/50 and reduce the tax on rental income.
Your total earnings are now £42,750, and you’ll pay the total tax of £6,503. (£5,280 tax on earnings and £1,223 tax on rental income).
Because your spouse’s earnings haven’t increased above the 40% taxable threshold, the tax on their portion of the rental income is charged at 20% and not 40%. That means the income tax on their rental profits is 20% x £5,250 = £1,050.
In total, by jointly sharing your investment property, you’ve saved £1,250 in income tax on your rental income.
If and when you do decide to sell your buy-to-let property, by owning jointly you’ll be able to use both your capital gains tax allowances and pay fewer capital gains tax.
Can you split property ownership unevenly?
In some cases, it would make sense for you to split your property ownership unevenly. Investment partnerships where you own, say, 70% of the property and the other party owns 30% will have income allocated in these proportions. You could agree on a different allocation – you own 70% but only get 50% of the income, for example – but there are special rules about how rental income is taxed in these scenarios. If this kind of complicated structure is what you want, then you’ll need to fill in a special form for the taxman.
If you’re married or in a civil partnership, the tax rules say that you’ll own the property 50/50. Your income will be allocated on this basis. It is possible for you to allocate a different shareholding, but you’ll need to complete a special form (called form 17) to let the taxman know.
We don’t like paying any more tax than we have to. We don’t want you to pay any more than you have to, either. You can use numerous strategies to minimise your tax on rental income and maximise your buy-to-let yield. However, your tax situation will be unique, so you should always get the advice of a tax expert – and that goes for any investment you make.
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