Tax Free Income Anyone?

The idea of tax free income is always appealing and there are a number of legitimate sources by which such income can be obtained. Individuals wanting to earn some extra cash and who have a spare room in their home can take advantage of the rent-a-room scheme and make up to £4,250 tax-free a year.

The rent-a room scheme was introduced in 1992 in a bid to increase the supply of private residential accommodation. To encourage people to let out spare rooms in their home, the rental income received is tax-free up to certain limits.

Main Residence

The scheme applies to rent received from letting a room in the individual’s main residence. This is essentially the home in which they live. It does not have to be a home that they own. The scheme applies equally to a room let in rented properties as it does to owner-occupied properties, although those in rental accommodation are advised to check the terms of the lease to ensure that sub-letting is permitted.

The range of properties that qualify is also wide. The room made available for letting does not have to be in a house. The scheme applies equally to flats, caravans, houseboats etc. The only condition is that the property is the individual’s main residence.

In the event that the individual has more than one home, the relief only applies to a room let in the property which is the individual’s main residence, in which he or she lives. Essentially, to qualify for the tax-free income the individual must share his or her home with a lodger. The relief does not apply to a room let in another property, the rent from which would be taxed under the normal property income rules.

Care must also be taken not to overstep the mark if the property has been divided into more than one residence, for example where a house has been split into flats or where the property has a granny annex. The rent-a-room relief is only available if the individual lets out the room is his or her own home. This means that if an individual divides his or her home into two separate flats, lives in one and lets the other out, rent-a-room relief will not be available. By contrast, if a room is let in the individual’s own flat, it will.

Tax Free Amount

The concept of the rent-a room scheme is simple. An individual lets out a room in his or her main residence and the rental income received is tax-free up to the exempt amount.

The exempt amount is £4,250 per tax year. The exempt amount is halved if someone else receives income from letting accommodation in the same property in the same tax year.

However, it is not further reduced if more people obtain rental income in respect of the same property. This means that where three or more people obtain income from letting accommodation in the same property, it is possible to receive tax-free income in excess of £4,250. For three people the exempt amount is £6,375, for four people, £8,500 etc.

The exempt amount is also reduced to £2,125 if the period of letting is less than 12 months and another person lets accommodation in the same residence at any time in a 12-month period that includes the short basis period.

The relief applies to gross receipts from furnished lettings in the individual’s home in the tax year. It not only covers rent but also payments made by the lodger for provision of goods and services in connection with the let, such as meals, laundry etc.

Example

Kirsty has just moved house and needs to earn some extra money to meet the additional costs. She lets out her spare room to a lodger. The lodger pays £300 a month.

The room is let out throughout 2007—08. Kirsty receives rental income of £3,600. As this is less than the exempt amount of £4,250, the income is tax-free under the rent-a-room scheme.

Under the rent-a-room scheme, no additional relief is given for expenses.

Complications

The rent-a-room scheme is simple provided that the rent received does not exceed the exempt amount. However, as the limit of £4,250 has not been increased since the introduction of the scheme some 15 years ago, it no longer covers commercial rents charged in some parts of the country.

The rent-a-room relief only applies automatically where the rent does not exceed the exempt amount. Once the rental income exceeds this amount, normal rules apply to work out the profit or loss arising. The profit or loss is found by deducting deductible expenses from the rent received for the tax year. If the individual has a property income business and lets other properties, the rent and expenses from the room let in the main residence simply goes into the pot when calculating the profits and losses for the property rental business.

However, there is an alternative. The individual can instead elect for the simplified basis to apply in respect of the let room. This simply taxes rent in excess of the exempt amount and ignores any expenses. The simplified basis is considerably simpler from and administrative viewpoint than working out the actual profit or loss. However, whether it is financially worthwhile will depend on the numbers.

Example

Phil lets out a room in his main residence. He charges rent of £400 per month. The room is let throughout 2007—08.

His expenses in connection with the let during the tax year are £500.

Rent received in the tax year is £4,800 (12 x £400). As this exceed the exempt amount under the rent-a-room scheme of £4,250 rent-a-room relief is not given automatically. Therefore, Phil’s income would be assessed on the normal basis.

His taxable profit for 2007—08 would be £4,300 (£4,800 - £500).

However, if Phil elects for the simplified basis to apply, he will instead be taxed on ££550 (rent of £4,800 less the exempt amount of £4,250).

This is clearly beneficial, not to mention simpler, and Phil should elect for the simplified basis to apply.

An election for the simplified basis must be made in writing within one year from 31 January following the end of the tax. Thus an election for 2007—08 must be made by 31 January 2010. Once made the election continues in force for subsequent years until withdrawn. The same time limit applies for withdrawing the election.

As, once made, the election continues to apply until withdrawn, it is necessary to review the position each year to ensure that the best result is achieved. The simplified profit calculation is desirable where it produces a smaller profit that derived from the normal method. As a rule of thumb, the simplified basis is beneficial where expenses are less than the exempt amount.

The other side of the equation is where the expenses are high and the rents are less than the exempt amount, such that rent-a-room relief is applied automatically. As no account is take of expenses where rent-a-room relief is given, any loss arising in connection with the let cannot be relieved. This means that if rents are less than the exempt amount and expenses exceed the rent, it is beneficial to elect for the relief to be disapplied in order to obtain relief for the loss.

The rent-a-room scheme provides a simple way to earn tax-free income from letting a room in one’s home. However, some number crunching is advised to ensure that the scheme gives the best possible result

Article by Sarah Bradford - Tax Writer for our Tax Insider webiste