Holiday let tax rules allow owners to escape thousands of pounds in tax

9th August 2023

• Income and capital gains on holiday let properties taxed less than those for ordinary rented properties

• TaxWatch analysis shows owners can pay thousands of pounds per year less in income tax, and tens of thousands less in capital gains tax

• Regime is being used to obtain significant tax breaks on what are essentially second homes

• Advisers say rules potentially allow significant reduction in capital gains tax on long-held second homes which were not previously let

 

A special tax regime for holiday lets allows landlords to pay thousands of pounds less in income tax each year, as well as significantly reducing the capital gains tax due when the properties are sold.

Analysis by TaxWatch shows an owner of a property earning £30,000 in rent can pay £4,000 per year less in income tax through the furnished holiday lettings (FHL) regime, compared to an ordinary longer-term let. The capital gains tax due upon a sale can be reduced by tens of thousands of pounds.

FHLs must meet certain conditions, such as the number of weeks they’re available for hire each year, but they can still be used by the owner for nearly half the time. The Office for Tax Simplification (OTS) found the regime is being used to obtain tax breaks in relation to what are essentially second homes¹OTS Property income review: Simplifying income tax for residential landlords, Office for Tax Simplification, 1 November 2022, … Continue reading.

Advisers are promoting that owners of long-held second homes, which were not previously let, can cut their capital gains tax bill, by letting as a holiday property for the last two years of ownership. This creates the potential for six-figure reductions.

Recent changes to the tax relief available for mortgage interest on let property mean the FHL rules have become particularly attractive to higher rate taxpayers, incentivising decisions to change from longer-term letting to holiday letting. This could exacerbate housing shortages, particularly in holiday hotspots.

 

Introduction

Generally, income and gains from rented properties have been taxed differently from trading businesses, on the basis that renting is a more passive activity than running a business. This caused regular arguments that some property letting was active enough to be classified as a property letting business and should, therefore, be taxed as a business anyway.

Special rules which took certain qualifying properties out of the property letting rules – known as the furnished holiday lettings (FHL) rules – were introduced in the early 1980s. The arrangements were intended to provide certainty over whether a short-term holiday rental business should be taxed as a business. They were specific to qualifying FHL properties only, and did not match ordinary business taxation rules.

The Office for Tax Simplification (OTS)²The OTS was an independent office of the The Treasury. See https://www.gov.uk/government/organisations/office-of-tax-simplification/ explored the issue of taxation of residential property income for individuals towards the end of 2022, comparing the two sets of rules. Here, we consider some of the findings of their report and the practical outcomes that arise in different situations, to identify who benefits and whether those benefits appear appropriate.

 

Legislative differences

To be classified as an FHL letting of the property must meet certain occupancy conditions. These include that the property is available for commercial letting for at least 210 days per year and actually let commercially for at least 105 days. This means that the property can be available for other uses, including personal use, for at least 155 days per year and potentially more if used in periods when available but not booked.

The following are the major taxation differences between FHL properties longer-term rental properties. In general, they treat FHL profits like profits from a business, but there are variations from this.

Mortgage interest relief (MI relief)

Since 2020/21, no deduction has been allowed for mortgage interest against income from longer-term lets in arriving at the profit to be taxed. Instead, a credit against tax of 20% of the MI is allowed, meaning that higher rate taxpayers do not benefit from higher rate relief. For some taxpayers, the change in treatment may result in them being pushed into a higher rate of tax, along with a number of other consequences relating to certain personal taxes and relief boundaries³OTS Property income review: Simplifying income tax for residential landlords, Office for Tax Simplification, 1 November 2022, … Continue reading.

For FHL properties, full MI relief is still allowed.

Capital allowances

Capital allowances are a deduction from income in relation to the purchase cost of fixtures and fittings used in a business. These are not due on the purchase of initial fixtures and fittings in a longer-term let property, but a deduction is allowed when such items are replaced.

FHL rules allow capital allowances to be claimed on initial fixtures and fittings. The Annual Investment Allowance (AIA) means that, generally, this will be a deduction for the full cost upfront – up to £1m per year.

Capital gains tax (CGT) on sale

Capital gains (being the increase in value of the property between purchase and sale ) on longer-term let property are generally taxed at residential property rates of 18% for basic rate taxpayers or 28% for higher rate taxpayers.

Properties classified as FHL qualify for Business Assets Disposal Relief (BADR)⁴Previously Entrepreneur’s Relief., which means that capital gains are charged at the reduced rate of 10% up to a current total lifetime limit of £1m.

In addition, FHL properties can qualify for other CGT reliefs including some which defer the point at which tax becomes due, potentially for many years after the original disposal.

Pension contributions

There are limits on the amount a person can contribute to a pension and receive tax relief for, which relate to the amount of income they have. Longer-term let property income is not included in calculating these potential pension contributions.

Income from FHL, however, is treated as ‘net relevant income’⁵Pensions Tax Manual, HMRC, 13 December 2022, https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm044100#earnings2/Research%20new/Property%20taxes/_top">https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm044100#earnings for the purposes of potential pension contributions. This allows increased contributions, on which tax relief can be obtained.

National Insurance Contributions (NICs)

NICs are generally not due on either longer term property rental income or under the FHL rules. However, this is where the regime strays from taxing holiday lets as businesses as NICs would be due on business income.

 

Example property

The following calculations demonstrate the differences in taxation outcomes for a sample property rented out under the different regimes. Any savings shown would change as actual figures, applicable tax rates etc, changed.

The calculations are based on the property being owned by a sample individual who:

• Owns their own home plus another residential property

• Most income is drawn from their own trading company as dividends

• Net relevant earnings for pension purposes (before FHL allowance) £30,000 pa (footnote).

• Pays income tax at the higher (40%) rate before rental income is considered

 

The property being rented in these calculations:

• Bought for £700,000 on 6 April 2020

• Income from property £30,000 pa

• Interest on £500,000 mortgage @ 3.2% APR £16,000 pa

• Initial fixtures and fittings £10,000

• Stamp Duty Land Tax (SDLT) paid on purchase £46,000

• Property maintenance etc costs £5,000 pa

• Sold for £900,000 on 5 April 2023

 

Applying the differing tax rules for longer-term lets and FHL produces the following results:

 

Income tax computations total three years 2020/21 to 2022/23⁶Full year by year calculations available here: Income tax table 1.pdf

		Let			FHL
Income		£90,000			£90,000
Mortgage interest				£48,000
Capital allowances				£10,000
Maintenance	£15,000			£15,000
Total costs		-£15,000			-£73,000
Net profit		£75,000			£17,000
Tax at 40%		£30,000			£6,800
MI relief	£48,000 x 20%	£9,600
Tax due		£20,400			£6,800
Saving					£13,600

 

Total income tax saving over 3 years under FHL rules: £13,600.

 

Capital gains computations on sale in 2022/23

Sale proceeds		£900,000
Purchase price	£700,000
Costs	£10,000
SDLT	£46,000
Total deductions		£756,000
Net gain		£144,000
Annual exempt amount		£12,300
Taxable gain		£131,700

Capital gains tax for long term let @ 28% = £36,879
Capital gains tax for FHL with BADR @ 10% = £13,170

Total capital gains tax saving on sale under FHL rules: £23,706.

Total income tax and capital gains tax saved under FHL rules: £37,306.

In this example, a higher-rate taxpayer could, therefore, save capital gains and income tax of around £37,000 over three years, by letting their property as a furnished holiday let rather than a longer-term let.

In addition, the FHL income would allow tax relief on potential additional pension contributions of £6,800⁷Additional net relevant earnings of £8,000 in 2021/22 (tax relief at 40% = £3,200) and £9,000 in 2022/23 (tax relief at 40% = £3,600)..

 

Example capital gains on property owned since mid-1980s

The savings are even more striking if a long-held property benefits from reduced capital gains tax rates, by being let as an FHL instead of a longer-term let.

Some advisors are even suggesting the reduced CGT rate can be achieved by turning a non FHL property into an FHL for two years before it’s sold, although analysis of the legislation suggests this is not clear cut (see explanation under “Who benefits” below.)

 

 

Sale proceeds		£900,000
Purchase price	£200,000
Costs	£10,000
SDLT	£2,000
Total deductions		£212,000
Net gain		£688,000
Annual exempt amount		£12,300
Taxable gain		£675,700

 

Capital gains tax for long term let @ 28% = £189,196
Capital gains tax for FHL with BADR @ 10% = £67,570

Total capital gains tax saved under FHL rules: £121,626.

 

Who benefits

127,000 FHL businesses were reported on UK tax returns in 2019-20 (around 17,000 of these involving properties in the EEA), which is the latest data that can be identified. These businesses can hold more than one property, so the regime affects more properties than this. However, this is a small proportion of the total 2.8m UK property businesses.

The OTS identified that there had been an 18% increase in the number of FHL businesses between 2016/17 and 2019/20 (the final year before full restrictions on MI relief). Data on commercial holiday lets registered for Business Rates (which have slightly different criteria but much overlap with, FHL) shows a 24% increase from 2019/20 to 2021/22⁸29 homes lost per day to the holiday homes sector, Generation Rent, 6 December 2022, https://www.generationrent.org/2022/12/06/29-homes-lost-per-day-to-the-holiday-homes-sector/.

The OTS survey identified that only a small number of FHL owners had a substantial holiday lettings business, with only 8% of respondents owning 4 or more properties. In comparison, the majority of landlords that benefited from the FHL rules own a single let property (around two thirds of respondents). In addition, their survey suggested that around 40% of such owners also made personal use of the property.

One issue not raised by the report is around the potential for obtaining BADR on the sale of a long-held property, just by converting it to an FHL for the last two years of ownership. This is being promoted by some advisers as a way of significantly reducing the capital gains tax due, from 28% (for higher rate taxpayers) to 10%.

This situation even crops up in a Chartered Institute of Taxation (CIOT) exam paper from a couple of years ago, with the suggested answer indicating that full BADR relief will be available⁹Application and Professional Skills Taxation of Individuals Suggested Answer, The Chartered Institute of Taxation, May 2021, … Continue reading. If this does work then, from our example, the possible saving of over £100,000 may make the hassle of operating an FHL for a couple of years seem worth it.

No specific HMRC guidance can be identified in relation to these circumstances but our initial analysis suggested this position was not quite so cut and dried. The legislation actually treats a qualifying FHL as a ‘trade’ for the purposes of of the BADR legislation. If the property is only used as an FHL for the final two years of ownership, it seems that the ‘trade’ – for the purposes of BADR – would only exist for those two years. In calculating capital gains, it therefore seems likely that HMRC would argue that only the gain arising on the property during the period of it being part of a deemed ‘trade’ would qualify for BADR. This would require a valuation of the property at the start of the FHL period, in order to calculate the gain to which ordinary rules apply prior to FHL use, plus a separate gain against which BADR can be applied.

We approached HMRC about this, in view of the lack of guidance, and their initial response indicated that a sale would only qualify for BADR for the period in which the property was used as an FHL, subject to other qualifying conditions. However, they have subsequently confirmed they are reviewing the matter further, on the back of our work. There’s clearly uncertainty around the position to obtain BADR on long held property and clients using the route may be unaware of this.

 

Comment

There are many arguments about the potential impacts on tourism of limiting FHL, but it is clear that properties being used as FHL are not available as homes.

As can be seen from the example above, there is the potential for significant tax savings on the same property under the two different regimes, though it should be recognised that there is likely to be significantly more work involved and potential wear and tear with a holiday let. But, even accepting that, the potential FHL tax savings appear to be very attractive, particularly to higher-rate taxpayers.

The increase in FHL returns and registered commercial holiday lets over the last few years suggests that this may have influenced a move towards FHL amongst landlords. However, the absolute numbers indicate that the regime only benefits a relatively small number of people.

The policy background to the FHL regime dates from a time when holiday lets required active management of short term rentals. The holiday letting industry has change significantly since the rules were introduced. Holiday lets can now be operated with much less active input by using agents and one of the many online platforms making them more akin to passive investments. This means that the business/non-business boundary is not such a relevant consideration, raising questions about the need for the distinct policy. In addition, the regime is actually more beneficial than that for a true business as FHL owners don’t pay National Insurance Contributions (NICs) giving them the best of both worlds.

In 2019-20, 2,000 taxpayers holding furnished holiday lettings claimed Business Asset Disposal Relief totalling gains of £366m, reflecting a tax saving of between £30m and £65m¹⁰OTS Property income review: Simplifying income tax for residential landlords, Office for Tax Simplification, 1 November 2022, … Continue reading but it is not clear that there is a current policy purpose behind allowing this relatively small group to gain such significant benefits.

Another issue to consider is the additional costs of compliance for HMRC arising out of the complex rules, including checking on the periods of commercial letting etc.

The OTS recommended that the government consider whether there was a continued benefit to the UK in having a separate regime for FHL. They suggested that a clear test could be brought in to identify a trade in holiday lets to deal with the uncertainty that existed before the FHL rules were introduced. This could have requirements including the operation of a number of properties and no private use, which would remove the significant benefits that potentially arise for second home owners.

From its survey, the OTS identified that some individuals have, essentially, purchased a holiday home for themselves but then use the FHL regime to gain tax benefits, particularly capital gains, while still using the property personally as much as possible. The OTS also recommended that, if the FHL rules were to be maintained, they should at least remove the possibility of personal occupation. It seems reasonable to question the existence of a tax regime that allows individuals to pay less capital gains tax on sale of their second home than the owner of a longer-term let property would pay.

Beyond the tax policy purpose, it may be that the availability of such tax incentives is also a factor to be considered when looking at problems with the housing market.

At a time when there is a large UK housing crisis, the tax benefits to these property owners appear unjustifiable. However, the report was produced just prior to the unexpected closure of the OTS, and there is no evidence of any plan for the Treasury or HMRC to respond to this report, or to take notice of its recommendations.

We would support the recommendations made by the OTS to review the policy purpose and operation of the FHL regime. Additionally HMRC need to clarify the current interaction between FHL and BADR by producing guidance on the matter. If relief is currently unrestricted we call on the Treasury to close this loophole, via a legislative change.

 

Post publication update