Advanced rent leads to higher net tax?

by Readers Question

13:45 PM, 16th October 2019
About a month ago

Advanced rent leads to higher net tax?

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Advanced rent leads to higher net tax?

I am helping a relative complete her tax return. She owns a property, run as an HMO, with a group of four tenants who have separate rooms. The rental agreements require rent one month in advance, but in August 2018, in addition to the regular monthly rent, all four paid 6 months rent in advance to cover the period 28/2/2019-30/8/2019 when they intended to vacate the property. As far as I can see, this was agreed by the letting agent without consulting my relative, but she accepted the payment, thereby, I guess, implicitly agreeing to it.

The payment, of course, straddles two tax years, and, from a previous forum thread, I think it is correct that how this is treated depends on whether one is doing “cash basis” accounting or “traditional accounting”. I don’t think any formal declaration on this has been made to HMRC, but in practice, previous tax returns have used cash basis.

My understanding of cash basis is that, since the payment was made in the 18-19 tax year, the whole amount counts as income in that tax year. This would increase her income by over 40% and push her into the higher rate 40% tax band with a consequent significant increase in total net tax paid.

This is clearly inequitable since, if the income was spread evenly over the two tax years, no extra tax at 40% would be payable. There are three things that occur to me that might avoid this.

1. Is it, in fact, correct that cash basis accounting requires this income to be taken in the 18-19 tax year? The “Help” screen for the TaxCalc package clearly says that rent that straddles two tax years should be apportioned, without saying “unless cash basis accounting is being used”. Possibly this is right and an exception is generally made for advance rent payments???

2. Presumably we could decide to use traditional accounting this tax year – but would we then be stuck with using it for all future years? Cash basis is much more convenient and normally gives the same results when averaged over multiple years. Clearly, however, in 19-20, the advance rent would have to be declared, but how would this be possible if we had reverted to cash basis?

3. Does HMRC have discretion to agree that we can use cash basis accounting for 2018-19, except for this advance rent payment that should be apportioned. If so, is there a preferred mechanism for asking them to agree to this?

I would be grateful for any guidance you can give me.

Ron

Editor’s Note:

Please see >> https://www.gov.uk/simpler-income-tax-cash-basis

Overview

‘Cash basis’ is a way to work out your income and expenses for your Self Assessment tax return, if you’re a sole trader or partner.

Why use cash basis

If you run a small business, cash basis accounting may suit you better than traditional accounting.

This is because you only need to declare money when it comes in and out of your business. At the end of the tax year, you won’t have to pay Income Tax on money you didn’t receive in your accounting period.

When cash basis might not suit your business

Cash basis probably won’t suit you if you:

  • want to claim interest or bank charges of more than £500 as an expense
  • run a business that’s more complex, for example you have high levels of stock
  • need to get finance for your business – a bank could ask to see accounts drawn up using traditional accounting to see what you owe and are due before agreeing a loan
  • have losses that you want to offset against other taxable income (‘sideways loss relief’)

Talk to a tax professional (such as an accountant) or legal adviser if you need help.

Find out if you’re eligible to use cash basis.

Please see >> https://www.gov.uk/government/publications/calculation-of-profits-of-property-businesses/income-tax-simplified-cash-basis-for-unincorporated-property-businesses

General description of the measure

Cash basis accounting (‘the cash basis’) is a simplified method for calculating taxable profits for those businesses with straightforward tax affairs.

Those with income from a property business (landlords) will be able to use the cash basis rather than generally accepted accounting practice (GAAP) to calculate their taxable profits. The new legislation will assume cash basis to be the default method of calculation, unless a landlord opts out or has rental receipts for the business in excess of the threshold in which case they will continue to use GAAP.

Policy objective

The measure will provide a simplification for those landlords with straightforward tax affairs and who don’t require accounts prepared under GAAP for any reason other to meet their tax obligations.



Comments

Neil Patterson

9:11 AM, 17th October 2019
About a month ago

Hi Ron,

To get definitive professional insured advice you will need to rely on an accountant you contract to submit and understand all your accounts and how they are declared.

However, please see my Editors Notes above at the bottom of your article.

It may be that if you have only ever submitted rental accounts as a landlord that HMRC have assumed you are working on a Cash Basis so you need to be sure HMRC are aware and happy if you are to try to pro rata the payment allocating to the corresponding months.

In my experience a good accountant will always at least save you what they cost so it is not worth the risk of going alone.

Rob Crawford

11:27 AM, 17th October 2019
About a month ago

I think you will find it's either cash accounting or accrual accounting. You can't pick and mix. But I wonder where the point of payment is? If on receipt of rent from the agent then maybe an arrangement for them to trickle the money to you on a monthly basis could be arranged. There would be associated risks, i.e. if the agent went into liquidation etc. However, if the agent is collecting rent on your behalf it would suggest this would not be acceptable. Any accountants out there?

Mark Alexander

14:38 PM, 17th October 2019
About a month ago

Reply to the comment left by Rob Crawford at 17/10/2019 - 11:27
I like that idea and I think it could solve the problem.

To mitigate risk of the failure of the Agent, I suggest it is imperative to ensure the Agent maintains a valid Cluent Money Protection insurance policy and is also a Member of ARLA or NALS or RICS.

Ron Bell

15:53 PM, 17th October 2019
About a month ago

Unfortunately I don't think that works because this is a one-off situation that has already happened. The advance 6 months rent was received by the letting agent in 2018 and since my relative did not question it at the time, I think it is now set in stone.
It would solve the problem:-
1. If we are allowed to use Cash Basis for 2018-19 except for treating just this advance rent payment on a pro-rata basis, OR
2. If we can use Accrual for 2018-19 but then revert to Cash Basis for 2019-20. I don't quite see how to do that, though. Accrual for 2018-19 would mean taking about 1/6th of the payment in 2018-19 and deferring 5/6ths to 2019-20. However, Cash Basis for 2019-20 would imply ignoring the 5/6ths because it wasn't actually received in 2019-20 - which, obviously HMRC wouldn't let us do since we'd be escaping the tax on it altogether.
Common sense says either do 1 above (just make a pro-rata exception to Cash Basis in 2018-19) or do 2 above and make an exception for the 5/6th in 2019-20. The question is whether HMRC's rules obey common sense!

Darlington Landlord

19:40 PM, 17th October 2019
About a month ago

why not continue using accrual going forward?, its not that complicated you just need to identify bills invoiced but not paid in a tax year and if you are likely to have a similar situation in the future it might be better. When MTD gets rolled out to landlords they will want you to pay tax quarterly - if you are on a cash basis and have annual expenses that could lead to big bills for a couple of low bill quarters and not enough in the bank for the annual buildings insurance for example.

Seething Landlord

0:32 AM, 18th October 2019
About a month ago

Reply to the comment left by Ron Bell at 17/10/2019 - 15:53
There is a box that you have to tick on the self-assessment form to say whether you have used the cash basis so I am certain that you cannot have any income or expenditure treated differently within the same tax year, it is all or nothing. When you switch from one basis to the other you have to make adjustments so that you end up paying the correct amount of tax overall This would normally be a one-off exercise although you would have to change back to the accruals basis if your rental income reached the prescribed level.
Having started to use the cash basis a couple of years ago I felt it necessary to refuse an offer of 6 months rent in advance for a tenancy starting in March this year as it would have meant it being taxed as received in total in the 2018 to 2019 tax year which would have been problematic.

Michael Barnes

13:13 PM, 18th October 2019
About a month ago

I believe that once you have switched to the cash basis you have to stick with it until circumstances change to make accruals basis mandatory.

One option might be to pretend that it did not happen, but if HMRC decide to audit you, then ...

Peter G

9:19 AM, 19th October 2019
About a month ago

Would it be naive to think that the HMRC would apply the same rules to income as they do for expenses? If they are consistent then you could use this explanation, as the HMRC rule for expenses says:
"If an expense covers more than one accounting period, you’ll need to spread that cost."
"For example, if your rent is payable 12 months’ in advance halfway through your accounting period, include half of the rent payable in the previous accounting period and half of the rent payable in this accounting period as an expense in your accounts for this year."
"Include the other half of the rent payable in this accounting period in your accounts for next year."

https://www.gov.uk/government/publications/how-to-calculate-your-taxable-profits-hs222-self-assessment-helpsheet/hs222-how-to-calculate-your-taxable-profits-2018--2#expenses

Seething Landlord

22:08 PM, 19th October 2019
About a month ago

Reply to the comment left by Peter G at 19/10/2019 - 09:19
It is not naive because that is precisely what HMRC do i.e. income and expenses are dealt with in the same way, either apportioned between tax years (accruals basis) or accounted for as received or incurred on the day of the transaction (cash basis). The guidance you have quoted describes what happens if you are using the accruals basis. If using the cash basis you should claim the whole rent as an expense incurred on the day that you paid it. That is my understanding but please do not rely on it - if in doubt take professional advice.

James Nelson

15:58 PM, 20th October 2019
About a month ago

If you don’t normally have advance payments then ordinarily there perhaps wouldn’t be any difference between the cash and traditional method ?

Therefore you have probably adhered to the traditional method even though you’ve been telling yourself that you’ve been doing the cash approach.

So perhaps it would not be a problem to apply the traditional approach to this one off payment ?

Pure speculation on my behalf I should add !

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