Ask The Taxwise ExpertQ. I have just purchased a property for the rental market and are unsure on what deposits would normally be requested of tenants and how these are treated. Can you offer any guidance on this area please?
A. This is an interesting question and as requested I give an overview on the different types of deposits and the way in which they are treated for tax purposes below.
Firstly let’s look at the most commonly used 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 areas such as damage to the property that extends beyond normally expected wear and tear. These could include the cost of having the property, including the carpets professionally cleaned, removing any rubbish from the property, unpaid rent etc. The items covered by the security deposit should be stated in the letting agreement.
The deposit charged can be up to two months’ rent, although in most cases six weeks’ rent is the regularly used amount. Deposits taken by a landlord or agent for an assured short hold 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 a 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.
If the deposit is retained and included as rental income for tax purposes then the actual costs incurred by the landlord in making good the damage or having the property professionally cleaned are an allowable deduction 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.
Another option commonly used by landlords are holding deposits, 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. If the holding deposit is returned, it does not form part of the income of the business for tax purposes. 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.
You should remember that for tax purposes 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 taxable 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.
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