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Deposits From Tenants
It is common practice for a landlord to take a deposit from a tenant when letting a property to cover the cost of any damage caused to the property by the tenant. A deposit of this nature may be referred to as a security deposit, a damage deposit or a rental deposit. The landlord may also ask for a holding deposit in return for taking the property off the market while the necessary paperwork is undertaken.
Security Deposits
It is normal practice for landlords to take a security deposit from tenants when letting residential property. The purpose of the deposit is to cover items such as damage to the property that extends beyond normal wear and tear, the cost of having the property, including the carpets, professionally cleaned, removing any rubbish from the property, unpaid rent and such like. The items covered by the security deposit should be stated in the letting agreement.
The deposit a landlord charges will vary. Charging six weeks rent for a security deposit is common practice, but landlords must ensure that they adhere to restrictions set out in the Tenant Fees Act.
Deposits taken by a landlord or agent for an assured shorthold tenancy in England or Wales are protected by Government authorised schemes. There are three possible schemes:
- the Deposit Protection Service scheme;
- the Tenancy Deposits Solution scheme; and
- The Dispute Service scheme.
To remove the need to go to court to settle disputes over retention and repayment of the deposit, each scheme features an alternative dispute resolution service. In the event that there is a dispute regarding the repayment of the deposit in the case of damage or unpaid rent, the alternative dispute resolution service will arbitrate.
The burden of proof falls on the landlord or agent, who will need to provide evidence to support their claim that all or part of the deposit should be retained. If there is no dispute, the tenant’s deposit should be returned to the tenant at the end of the tenancy.
The extent to which the deposit is included as income of the rental business depends on whether all or part of the deposit is retained by the landlord. In a straightforward case where a security deposit is taken by the landlord, held for the period of the tenancy and returned to the tenant at the end of the rental period, the deposit is not included as income of the property rental business.
However, if at the end of the tenancy agreement the landlord retains all or part of the deposit to cover damage to the property, cleaning costs or other similar expenses, the amount retained is included as income of the property rental business.
The retained deposit is a receipt of the business in the same way as rent received from the tenant. However, the actual costs incurred by the landlord in making good the damage or having the property professionally cleaned are deducted in computing the profits of the business.
The retained deposit is reflected as rental income of the property rental business for the period in which the decision to retain the deposit is taken, rather than for the period in which the deposit was initially collected from the tenant.
Example
Bill purchases a property as a buy to let investment. He lets the property out in September 2009. He collects a security deposit of £1,000 from the tenant. The terms of the deposit are set out in the tenancy agreement.
The let comes to an end in September 2011. When checking out the tenant, it transpires that the tenant has failed to have the carpets professionally cleaned, as per the terms of the agreement, and also that he has damaged a door, which needs to be repaired.
After discussion, Bill and the tenant agree that Bill will retain £250 of the deposit to cover cleaning and repair costs. The balance of the deposit (£750) is returned to the tenant in October 2011.
Bill spends £180 having the carpets professionally cleaned and £75 having the door repaired.
Bill prepares accounts for the property rental business to 31 March each year.
When preparing accounts for the year to 31 March 2012, Bill must include as income the £250 retained from the tenant. However, he can deduct the actual cost of cleaning the property (£180) and repairing the door (£75). As the amount actually spent (£255) exceeds the amount retained, he is given relief for the additional £5 in computing the profits of his property rental business.
The balance of the deposit returned to the tenant is not taken into account as income of the business.
As stated in the article on use of the property rental toolkit in our September issue, HMRC recognise that accounting for deposits can sometimes cause problems. Guidance on income that should be taken into account in computing the profits of a property rental business can be found in their Property Income Manual at PIM1052 (see https://www.gov.uk/hmrc-internal-manuals/property-income-manual/pim1052 )
Holding Deposit
Holding deposits are another form of deposit commonly taken by landlords, particularly in periods where the letting market is buoyant and demand for property is high. As the name suggests, a holding deposit is paid by the tenant to secure the property while the tenancy agreement is signed. In return, the landlord will take the property off the market.
A holding deposit is usually in the region of one week’s rent. The terms governing the use of the deposit and the circumstances in which it may be retained by the landlord should be set out in a holding deposit agreement so all parties know where they stand.
In the event that the let falls through and under the terms of the agreement the landlord retains some or all of the deposit as compensation for the inconvenience and costs incurred in relation to the prospective let, the amount of the retained deposit should be included as income of the property rental business. However, the landlord would be able to claim a deduction for any costs actually incurred in relation to aborted let, such as advertising or legal fees.
In the event that the let goes ahead, the holding deposit would either be returned to the tenant or used to form part of the security deposit (see above). If the holding deposit is returned, it does not form part of the income of the business. Where the holding deposit is used as part of the security deposit, as explained above, it is only taken into account to the extent that it is retained by the landlord to cover damage etc. at the end of the let.
Practical Tip
As a general rule, deposits taken from tenants only form part of the income of the property rental business to the extent that the deposit is ultimately retained by the landlord. Any deposits that are merely held on the tenant’s behalf before being returned to the tenant are not taken into account as income. On the other side of the coin, a deduction is given for any costs actually incurred by the landlord in making good damage etc. covered under the terms of the deposit agreement.
Tax Treatment Of ‘Gifted Deposits’?
A recent case before the First-tier Tribunal (Day and Anor v Revenue & Customs [2015] UKFTT 142 (TC)) holds some valuable lessons for landlords selling a buy-to-let property.
One of the properties in the above case had been sold using a ‘gifted deposit’ scheme.
Gifted Deposit Schemes
These schemes used to be very popular and were promoted as a way of becoming a property owner without having to come up with any of the purchase price. The seller of the property would agree to take (say) 5% less than the asking price (which was itself often a somewhat inflated one), but this would be done by the seller making a ‘gift’ to the buyer of the 5% difference. The buyer could then obtain a 95% mortgage on the stated purchase price, but the other 5% was provided by the seller so the buyer had none of their own money invested in the property.
Everyone seemed quite relaxed about this practice, even though to me it looked very much like a fraud on the lender of the money if they were not informed about the ‘gift’. I recall raising this with a senior manager at one of the high street banks and asking what he thought about it. He asked me one question: ‘In this hypothetical situation, does the buyer keep up with the mortgage payments?’ When I replied ‘yes’, he gave me his professional opinion: ‘Why should I care, then?
This particular scheme was operated in the above case with the full knowledge of the lender involved – indeed the scheme was organised by the Halifax. Under the scheme, Mr Day and his co-investor effectively paid the 5% deposit on the sale to themselves, purportedly on behalf of the buyers, and the Halifax provided the buyers with a loan of the other 95% of the sale price. The point was to enable the Halifax to lend the buyers the whole of the actual purchase price whilst being able to record it as a 95% mortgage rather than a 100% one.
Tax Treatment
HMRC contended that the sale proceeds for capital gains tax (CGT) purposes should be the whole amount shown in the sale documentation (£66,300), rather than the price after the ‘gifted deposit’ of £62,985.
The Tribunal described the £66,300 as ‘a label’ and agreed that the correct sale proceeds were the amount after the gifted deposit – £62,985.
The important point, however, was what they said about gifted deposits in general and their view of the rights and wrongs of them. In the Day case, the gifted deposit had been paid with the full knowledge (indeed, with the encouragement) of the Halifax, the lender concerned. The Tribunal suggested their view might have been very different if the deposit had been ‘gifted’ without the lender’s knowledge (as many were when this was a popular ruse in the buy-to-let market).
They did not mince their words, either:
“If the appellants had fraudulently paid the deposit in order to help the purchasers obtain a 95% mortgage, we might well not have been persuaded that the appellants could rely on that fraud to reduce their tax liability.”
The thing that saved Mr Day and his co-investor was that this was one of the ‘respectable’ gifted deposits, because the lender concerned knew about it and indeed was promoting it. Things might have been very different if it had been one of the ‘under the counter’ schemes that were around at the time.
Practical Tip
If you bought a property using a gifted deposit scheme, the correct purchase price for CGT purposes when you come to sell it is likely to be the price net of the gifted deposit. If anyone suggests using a gifted deposit, make certain the lender is fully aware of what is going on, and agrees to it.
