Letting Property Below A Market Rental – The Tax Implications

James Bailey highlights a tax pitfall on letting your property at a rent significantly lower than on the open market.

A landlord may allow a tenant to occupy a property and pay less than the market rent because either the tenant is a friend or relative, or the tenant has something to offer worth more than the rent.

If you allow someone to occupy a property and, for personal reasons, charge them a rent significantly lower than you could get on the open market, then strictly speaking this letting is separate from any other properties you may own, because this letting is not being done for business reasons. It is therefore not part of your UK property business.

HMRC take the view that this means you have no right to claim expenses against the rental income, but by concession, they are prepared to accept claims for expenses up to the amount of the rent received. In other words, they will not accept that the ‘friendly’ letting of this property can create losses to set against other property income.

By the same token, if there are no expenses and there is a profit on this letting, then it must be treated as taxable – losses from other properties cannot be used against it.

Other reasons for low rentals

If you can make a business case for agreeing to reduce the rent, then different rules apply.

The three commonest reasons, other than personal ones, for agreeing to a low rental are:

• The tenant agrees to carry out work on the property at his own expense in return for a reduced or nil rent.

• The tenant is occupying by way of being a caretaker, living in the property whilst work is being done on it when a normal tenant would not agree to do so at a full rental.

• The tenant is a prestigious name (think of Marks & Spencer, or a high street bank), who will attract other quality tenants to your development.

The treatment here depends on whether the work is normal repairs and maintenance, in which case all that is happening is that the tenant is paying his rent in kind rather than cash and the property can be included as part of the normal rental business, or whether the work is capital in nature and as such could not be claimed as an expense by the landlord. 

In such a case the landlord is treated as if he had been paid a premium for the grant of the tenancy, equivalent to the difference between the value of the property with no repairs, and the value (when the tenant moves in) of the property as a result of the agreement to do repairs. This can be a quite complex calculation – for example, you have to take account of the fact that the landlord cannot benefit immediately from the increased value because he has a tenant there), and you will need professional advice on this.

Providing you can show that there is a real benefit from having someone there – the property is in a high crime neighbourhood, for example – then this is a commercial arrangement and the property can be included as part of your rental business.

Provided the only inducement to the tenant is a rent free or low rent period, then as with the caretaker tenant, there is a commercial reason for the agreement and the property (and its expenses) will be part of the normal property business. 

If you agree to a reduced rent for personal reasons then this will affect what expenses you can claim on the property in question; if the low rent is commercially justifiable, it will not affect the claims for expenses on the property.