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This is the third part of a series which has looked at the different methods of accounting landlords can use and what the pros and cons are taking into account the current Covid pandemic.
Our sister site Tax Insider helps landlords and other taxpayers to understand taxation matters and to reduce their tax burdens. In this last of three guest posts from Tax Insider you can learn which calculation method is best, the cash basis or the accrual basis taking into account the pandemic and how this might impact each method of accounting. The article also looks at some case studies to help you decide which method of accounting is right for you and how to assess whether changing your method of calculation will reduce your tax liability.
Which Method Of Calculation Is Best?
As ever the decision will depend upon calculation and the different circumstances of each landlord including the amount of rental income received, the type of any other income and the landlord’s marginal tax rate for the year. Whilst the main advantage of the cash basis is simplicity, it could, in certain circumstances, produce a higher overall tax liability over two or more years. This is because the cash basis accounts use the date of receipt or payment rather than the more predictable accruals basis that evens out the amounts over two years.
Seeing their rental income drop due to tenants paying late, paying some but not all or not paying anything under the coronavirus crisis may lead those landlords affected to automatically apply the cash basis thinking that it is the easier calculation or possibly that that basis will result in a lower tax bill.
The following example shows both methods of computation and how the accrual basis could produce a more tax efficient result even though some rental payments have not been paid on time.
Example 1
Susan is employed earning £40,000 per annum taxed under PAYE. She also rents out a property for £1,500 a month and has expenses of £250 per month for management fees and £500 per month for mortgage interest.
Her tenant was self-employed and as a result of the coronavirus lockdown had to cease work. Unfortunately as he had only started his business in June 2019 he was unable to claim under the Self Employed Income Support Scheme. Susan therefore agreed to defer payment of rent. Unfortunately as at 5 April 2021 three months’ rent remained unpaid. The tenant left on 1 May 2021 when outstanding payments were settled in full from the Tenant Deposit scheme.
Note: the calculation assumes that the same allowances and tax rates apply for both years. The difference in using the accrual basis in comparison with the cash basis is £800.
Accruals basis 2020/21 and 2021/22
| Employment income | £40,000 |
| Net rental income | |
| ((£1,500 -250) x 12) | £15,000 |
| Taxable income | £55,000 |
| Less personal allowance | £(12,500) |
| Taxable | £ 42,500 |
| Tax liability | |
| £37,500 x 20% | £ 7,500 |
| £5,000 x 40% | £ 2,000 |
| Less Mortgage interest reduction | |
| £6,000 x 20% | £(1,200) |
| Tax liability | £ 8,300 |
| Total tax liability for both years | £16,600 |
Cash Basis
| 2020/2021 | 2021/2022 | |
| Employment income | £ 40,000 | £ 40,000 |
| Net rental income** | £ 6,000 | £ 24,000 |
| Taxable income | £ 46,000 | £ 64,000 |
| Personal allowance | £(12,500) | £(12,500) |
| Taxable | £ 33,500 | £ 51,500 |
| Tax Liability: | ||
| £33,500 x 20% | £ 6,700 | 0 |
| £37,500 x 20% | £0 | £ 7,500 |
| £14,000 x 40% | £0 | £ 5,600 |
| £ 6,700 | £13,100 | |
| Less mortgage interest reduction | £(1,200) | £1(2,00) |
| Tax liability | £ 5,500 | £11,900 |
| Total tax liability for both years | £17,400 |
** 2019/20 – £1,500 x 3 = £9,000 less £250 x 12 (£3,000) = £6,000
2020/21 – £1,500 x 15 = £27,000 less £3,000 = £24,000
Transitional Arrangements
As an effect of the reduction of rental income and possible profit for 2020/21, a landlord who previously used the accrual basis may find that the cash basis is more beneficial. If this is the case then on switching from the accrual to the cash basis, ‘transitional arrangements’ will need to be applied. In this situation not only is it important to ensure that all income and expenditure is taken into account over both years but also that there is no ‘double accounting’ so that no items are omitted or counted twice.
If a switch is made to the cash basis by default or otherwise, then it will be necessary to make the following adjustments:
- where money was owed to the business at the end of the previous year (debtors) and taken into account in computing profits for that year, the money must not be taken into account as a receipt when received in the cash basis year; and
- where money was owed to suppliers at the end of the previous year (creditors) and relief was given in computing profits for that year, no deduction must be given in the year that the bill is paid.
Unlike the accrual basis, when using the cash basis of calculation, equipment purchased for use in the business is claimed as a normal allowable business expense rather than as a capital allowance. However, going from an accrual to a cash basis means that there will be a capital allowance ‘pool’. In this instance, the unrelieved amount relating to this equipment can be relieved in full for the first year under the cash basis. However, the amount relating to the car is excluded from the transitional adjustment calculation and as such capital allowances will continue to be claimed thereon.
Example 2
Julian rents out a property and a new tenant agrees to pay a deposit of £6,000 on 1 March 2020, covering the first three months’ rent. However, the tenant lost his job in June and was unable to pay the July month’s payment. Under the coronavirus rules the tenant and Julian agree to a deferment of rent.
Julian uses the ‘accrual’ method of calculation for the 2019/20 year but forgets to claim to ‘opt out’ of the ‘cash basis’ for the year 2020/21. In the 2019/20 accounts, two months (£2,000) of income would have been deferred until the 2020/21 year. This amount needs to be included in the 2020/21 accounts as a transitional adjustment otherwise the amount would never be brought into account under the cash basis as it had been paid in 2019/20.
In addition, should the business have unrelieved qualifying capital allowances at the end of the previous (‘accrual’ basis) period, amendments to the calculation will be required, otherwise the landlord will not receive the full allowances to which he would have been entitled if the basis had not changed. Where a capital allowance pool contains cars as well as other plant and machinery, the amount relieved must be apportioned on a just and reasonable basis (allowance for cars being specifically allowed for under the cash basis). The written down value is therefore treated as an expense in the first year of the cash basis.
Example 3
Carlo has always been taxed under the ‘accrual’ basis for all years to 2019/20 but enters the default ‘cash’ basis for the 2020/21 tax year because he agrees to defer rental payment on two out of his three properties under the coronavirus rules and decides not to ‘opt out’. As at 5 April 2020, the business had unrelieved capital expenditure in a capital allowances pool of £8,000. Because the pool is mixed, a just and reasonable basis is used to apportion the unrelieved amount of pool value brought forward. It is determined that £2,000 of this relates to the car and the remaining £6,000 relates to the equipment. £6,000 can be deducted in calculating the profits of the 2020/21 tax year with the remaining £2,000 remaining in the capital allowances pool enabling a claim under the capital allowances rules.
Written by Jennifer Adams:
Jennifer Adams is a property tax specialist with a flair for helping clients structure their financial affairs in a tax-efficient manner. She appreciates the tax problems of property owners having a property portfolio herself. Jennifer writes for many leading publishers and can be relied upon for simple, straightforward advice. She runs her own accounting practice and her advice and specialist knowledge enables all of her clients to pay the least amount of tax that is legally possible.
Tax Insider publishes monthly newsletters and reports for everyone with an interest in responsible tax saving, including professional advisors, landlords, property investors, business owners, and general UK taxpayers. For more information and the latest property tax saving tips, visit the Tax Insider website.
