Cash basis for landlords
From 6 April 2017 onwards, the cash basis is the default basis for eligible unincorporated property businesses which pass the cash basis eligibility tests. Unincorporated property businesses which do not pass the tests must continue to prepare accounts using the accruals basis, as must corporate landlords. Landlords which qualify forthe cash basis can, if they prefer, elect to use the accruals basis instead.
The move to the use of the cash basis represents a simplification measure in readiness for the introduction of Making Tax Digital. In August 2016, the Government consulted on the extension of the cash basis to unincorporated property businesses, being one of the measures designed to ease the transition to a digital age. Other measures included changes to the cash basis entry threshold to open it up to larger businesses and changes to the treatment of capital items.
Under Making Tax Digital (MTD), businesses will be required to keep track of their tax affairs digitally and to provide digital reports to HMRC quarterly. The original timescale for the introduction of MTD has been revised and, at the time of writing, the plan is that MTD will be introduced for VAT only from April 2019 for VAT-registered businesses whose turnover is above the VAT registration threshold. This is set at £85,000 from 1 April 2017, and will remain at this level until 31 March 2020. Other businesses will not now be asked to record and report digitally until at least 2020 – and it will only then be mandatory where turnover exceeds the VAT registration threshold.
Under Generally Accepted Accounting Practice (GAAP) – the accounting rules and standards that govern financial reporting -- profits must be worked out using the accruals basis. The accruals basis, which is sometimes referred to as the `earnings basis’, recognises income earned in a period and expenditure incurred in a period. It does not matter whether the amounts have been received or paid in the period. The income and expenditure is matched to the period to which each relate, rather than to the time at which the income was received or when the payments were made. This means that under the accruals basis it is necessary to take account of money owed (debtors) and money (owing) and also prepayments and accruals. By contrast, the cash basis works essentially on the basis of cash in and cash out. Income is recognised when payment is received and expenditure is recognised when payment is made. The cash basis is a simpler basis and requires less adjustments at the year-end. For example, there is no need to calculate prepayments and accruals as there is under the accruals basis. Further, tax is only assessed on profits that have been realised.
From 6 April 2017, the availability of the cash basis is extended to unincorporated property businesses whose rental income does not exceed the eligibility threshold, which is set at £150,000. Property companies cannot use the cash basis and must continue to prepare accounts on the accruals basis. Unlike traders, for unincorporated property business the cash basis is the default basis where the eligibility conditions are met, and consequently landlords eligible to use the cash basis must elect for the accruals basis if they do not want to use the cash basis to prepare their accounts. By contrast, eligible traders wishing to use the cash basis must elect to do so. Most landlords are individuals and as long as the eligibility criteria are met, the cash basis will apply unless they opt for the accruals basis. Likewise, partnerships can use the cash basis (as long as rental income is not above the threshold) if the partnership comprises only of individuals; those with one or more corporate partners are excluded from the cash basis, as are limited liability partnerships. The availability of the cash basis is not limited to UK property businesses – it is also available in respect of overseas property businesses and furnished holiday lettings where the eligibility criteria (see Section 6) are met. Eligible non-residents landlords would also be within the scope of the cash basis.
The legislation for determining whether the cash basis applies to a landlord by default is framed in the form of five tests – A, B, C, D and E. If none of the tests is met, the cash basis applies by default. However, if any of the tests is met, the business will not be eligible to use the cash basis and must continue to prepare accounts by reference to the accruals basis.
Test A is met if the business is carried on at any time in the tax year by:
• a company;
• a limited liability partnership;
• a corporate firm;
• the trustees of a trust;
or • the personal representatives of a person.
A partnership is treated as a `corporate firm’ (and thus not eligible for the cash basis) if a partner in the firm is not an individual.
Test B is met if the cash basis receipts for the year exceed £150,000. The cash basis receipts are those that are taken into account in working out the profits of the property business on a cash basis. This is explored further in Section 13 below. This test limits the availability of the cash basis to smaller property businesses with receipts of £150,000 a year or less. Larger property businesses with receipts in excess of this limit are excluded from the cash basis and must continue to use the accruals basis to work out profits.
Where individuals who are married or in a civil partnership and who live together own property jointly, for income tax purposes, the income is split equally between them (by virtue of ITA 2007, s. 836). Condition C prevents the cash basis from applying where a landlord receives a share of joint property income (treated as arising to the joint owners in equal shares under ITA 2007, s. 836) and the profits of another person (i.e. the landlord’s spouse or civil partner) also receiving a share of that joint property income are calculated in accordance with Generally Accepted Accounting Principles (GAAP). Where this is the case, the individual must also use the accruals basis to calculate profits in accordance with GAAP. This test means that where a property is owned jointly by spouses or civil partners, they must use the same basis to compute their profits. Consequently, if one party is not eligible for the cash basis, the cash basis is not available to the other party in respect of the property business receiving a share of the joint income.
A landlord is also prohibited from using the cash basis if condition D applies. This test is met if a Business Premises Renovation Allowance is made in calculating the profits of the business property business and a balancing event in the year would give rise to a balancing adjustment. Where this is the case, profits must be computed using the accruals basis in accordance with GAAP.
Test E is only relevant where none of A, B, C or D are met. Test E is that the landlord has opted out of the cash basis by electing forthe accruals basis to apply. Unless such an election is made and none of tests A to D is met, the cash basis will apply. However, where an election to opt out of the cash basis is made, the cash basis does not apply and the accruals basis will apply instead. None of A, B, C, D or E apply If none of the tests A, B, C or D are met and the landlord has not opted out of the cash basis, the cash basis applies by default.
In general, individuals who are not married or in a civil partnership and who own property jointly without being in a formal partnership will each be able to decide whether to remain in the cash basis where the cash basis applies by default, or whether to opt for the accruals basis. The decision by one individual is not binding on other individuals and there is no requirement that all joint owners use the same basis.
Under the cash basis, expenses are recognised when paid – they are not matched to the period to which they relate as under the accruals basis. Consequently, there is no need to worry about prepayments and accruals. However, there is no difference in the type of revenue expenses that are deductible – only in the time when relief is given (although different rules apply to capital expenditure). As under the accruals basis, only expenses which are incurred wholly and exclusively for the purposes of the property income business can be deducted under the cash basis.
Common expenses that are deductible in computing profits include letting agent’s fees, advertising costs, cleaning costs, landlord’s insurance, stationery, postage and printing costs, staff costs and such like.
From 6 April 2017, most items of capital expenditure can be deducted (on a date paid basis) in computing the cash basis profits of the property income business. This gives immediate relief for the expenditure against profits. However, certain types of capital expenditure do not qualify for deduction. No deduction is allowed for capital expenditure that is incurred on or in connection with the acquisition or disposal of a business or part of a business. Likewise, no deduction is available in respect of expenditure on an item of a capital nature which is incurred on or in connection with the provision, alteration or disposal of: • any asset that is not a depreciating asset; • any asset that is not acquired for use on a continuing basis in the trade; • a car; • land; • a non-qualifying intangible asset, including education or training; or • a financial asset. A depreciating asset is one which within 20 years is either no longer of use as a business asset or has a value of ten per cent or less of its value at the time that the expenditure on it was originally incurred. The rules mean that, unsurprisingly, a landlord would not be allowed to deduct the cost of purchasing a property which is let out – as usual, gains or losses are dealt with under the capital gains tax rules. However, where he buys a capital item, such as say office furniture, the cost of that furniture can be deducted by reference to the date of payment when computing the cash basis profits of the property income business. Where the let is a residential let, relief for expenditure on replacement domestic items is given in accordance with the rules explained in Section 18 below. If a deduction has been given for the cost of the capital item, in the event that the item is subsequently sold, the sale proceeds are taken into account as a receipt of the property income business when the cash is received.
Where the let is a residential let, other than a furnished holiday letting, the normal relief for the replacement of domestic items applies where profits are computed on the cash basis. Under these rules a deduction is given for expenditure on replacement items of furniture, furnishing, appliances (including white goods) used in the let property. The amount which is eligible for deduction is relation to the replacement item is the cost of the replacement item, plus any associated costs of acquiring the new item (such as delivery) or disposing of the old item, less any proceeds received in respect of the disposal of the old item. The cost is capped at the cost of an equivalent standard replacement to the original – where the replacement is superior, the `improvement’ element is not deductible.
Landlords (regardless of whether they use the cash basis or not) can opt to use fixed rate per business mile to calculate their allowable deductions for motoring expenses rather than deducting actual running costs and claiming capital allowances. The option for landlords to use mileage rates was announced at the time of the 2017 Autumn Budget and is available from 6 April 2017 onwards. However, corporate landlords or those in a partnership with individual and non-individual members are not able to claim mileage rates. The mileage rates are the same as those available to traders – 45p per mile for the first 10,000 business miles and 25p per mile for any subsequent business miles in the tax year for cars and vans and 24p per mile for motorcycles. Where a landlord has claimed capital allowances in respect of a car or a deduction for the cost of a van or motorcycle under the capital expenditure rules, mileage allowances cannot be claimed for that vehicle. This is because the mileage rates allow for depreciation.
Relief For Interest
Relief for interest and financing costs incurred in relation to the property business is given in the same way under the cash basis as under the accruals basis. Where the property is a residential property, the method of relief is moving from relief by deduction to relief as a basic rate tax deduction. These rules apply equally underthe cash basis. During the transitional period, relief is available as follows: • for 2017/18, relief for 75% of the interest and finance costs is given by deduction, with relief for the remaining 25% as a basic rate tax reduction; • for 2018/19 relief for 50% of the interest and finance costs is given by deduction with relief for the remaining 50% as a basic rate tax reduction; • for 2019/20 relief for 25% of the interest and finance costs is given by deduction with relief for the remaining 75% as a basic rate tax reduction; • from 2020/21 onwards, relief is given wholly as a basic rate tax reduction. For non-residential properties and furnished holiday lettings, relief continues to be given by deduction, although landlords are not prevented from using the cash basis where interest costs are more than £500 a year(as is the case underthe cash basis rules as they apply to traders). Relief for interest on loans is capped on loans to the value of the property when first let.
Planning And Timing Issues
Under the cash basis, income is only recognised when it is received and expenditure when paid. From a tax perspective, this means that the landlord will not have to pay tax on income before it has been received and also that relief is automatically given for bad debts. On the other side of the coin, relief for expenditure is not given until the payment has been made. This may mean that relief is given in a later tax year under the cash basis than under the accruals basis. Relief for expenditure can be accelerated by making the payment early or advancing the expenditure to bring it into an earlier tax year – for example, paying a bill on 28 March 2018 rather than on 10 April 2018 will mean relief is given in 2017/18 rather than in 2018/19. Where the cash basis applies, the desire to delay tax on income and advance relief on expenditure creates something of a conflict with good cashflow management. The tax rules benefit income being received as late as possible and payments being made as early as possible, whereas from a cashflow perspective the opposite is true. As always, the tax tail should not be allowed to wag the dog.