How does rental income work?

Buying a rental property can boost your passive income 

Passive income is money that you earn from an asset or source that requires very little work or effort from you. It goes without saying that passive income is far more attractive than having to work for money but to get passive income you generally need to at least invest time and money upfront and be ready to take some responsibility and risk. 

So what passive income ideas are there? You can get it from stocks and bonds, but one of the most obvious forms of reliable passive income is rental income. This works very well for many people, but it also brings landlord’s responsibilities, financial commitments, maintenance, and don’t forget tax. 

It is important to sit down and carefully run through whether it makes sense for you personally. This article will help you to structure that thinking and get started. 

Make sure you can afford it before making an investment 

First up, you need to be sure you can actually afford to divert your savings to an investment in property. That’s because you are going to have to put up some cash for a deposit and taxes, not to mention ongoing maintenance. 

Make sure you have enough money left for 3-6 months of emergency expenses - such as car or home repairs. Money Dashboard can help you explore your spending, where you can tighten up and if you have a reserve that you can draw on across your accounts. 

And, if you have outstanding credit debt or other debt – clear it now. Property is a medium to long term game, and is it always best to manage your debt right down before investing. Not being able to do emergency repairs on your rental property is going to get you into trouble. Unhappy tenants will cause you (and them) undue stress and can threaten the returns you make on your property if tenants are constantly churning over and leaving it empty in between contracts. 

Set out and quantify your rental property expenses checklist. This includes upfront costs and ongoing maintenance. Upfront costs typically include necessary repairs when you get the property, any decorating to get the property ready for the rental market, and safety improvements including gas appliances and providing furniture that complies with fire safety regulations. Ongoing cost examples may be boiler repairs, furnishings, painting and minor repairs.

Getting a mortgage 

If you are renting out your own home, you need to tell your mortgage provider.

If you’re buying a property to let, and need to borrow, so you can get a ‘buy to let mortgage’. In a nutshell, the process is similar to getting a mortgage for your own place in that they will check all your details and credit worthiness. But there are some important differences. Most obviously, the fees are generally higher than with a personal mortgage. Interest rates are also generally higher.

The good news is as long as you are creditworthy many lenders will look at your mortgage as a business loan and pay less attention to your income. If you can demonstrate that rental income will exceed costs by a good margin, then you have a viable business. 

Use a comparison website to help find a mortgage provider and don’t forget to shop around for the best interest rates. 

Don’t fear tax

No one loves paying tax, but when it comes to rental income, paying taxes is a sign of a successful, profitable venture. Let me explain. 

You are going to need to do a self-assessment tax return to declare any rental income you get to HMRC. You must do this before each year’s deadline or you could face a fine. 

The good news is that costs like maintenance, insurance, letting agent fees and interest paid on mortgages (although this is being phased out in 2021), will reduce your taxable income. For example if you earned £10,000 in rental income and incurred £3,000 of costs, you are only taxed on the profits – the £7,000 difference. 

If things are not going well financially (such as your property remaining empty or large repair bills) and you face a net loss, then you can carry forward the net loss and offset it against future years’ profit. So if you only earned £7,000 in rental income, but had £10,000 of expenses, your loss was £3,000. You’ll pay no tax on the rental income this year, and next year you can deduct the £3,000 from any taxable profits. 

The rental income tax rate will be the same as your top rate of income tax because rental income is not deductible from employment or a business income. So if you earn enough to cross the 20% or 40% income tax rate threshold, that’s what you’ll pay on your rental profit too. 

You do get a property income allowance which exempts you from paying tax on the first £1,000 a year income from property. A jointly owned property means you’ll both get the allowance. But watch out here – you cannot also claim expenses if you use this allowance so if expenses are over £1,000 you are better off claiming them instead. 

So, do your self-assessment, and if you are still paying tax on rental income, congratulations – you are a profitable property business. 

When you sell your property, you will probably have to pay Capital Gains Tax if it has grown in value. However rough this feels, remember to celebrate your profits there too. 

Stamp Duty holiday ends March 31st 2021

The Chancellor announced back in July 2020 a Stamp Duty holiday until 31st March 2021. Something similar has been applied across Scotland and Wales too. This means, for example, in England that if the property you are buying is worth less than £500,000 you will pay no stamp duty. Depending on how much you are spending this could save you a few thousand (and if you are spending £500,000 or more, it will save you £15,000). 

However, buyers of second properties still have to pay ‘additional property’ tax in all countries in the UK, but you will still benefit from the holiday on the main Stamp Duty tax. If you want to benefit from this – act quick – it can take months to complete and there is no guarantee the Chancellor will renew the holiday from April. 

Get the right place 

Buying property can be fun! 

Are you dreaming of a little bijou one-bed place in a historical building, the one you fantasise about living in yourself in a parallel life in which you are a freewheeling yogi bohemian? Yes, it needs a kitchen at some point, and of course, the maintenance is a big question mark, but wouldn’t it just be so cool to own a little place like that. 

Take that thought, cast it upon the ground, stamp on it, and never speak of it again. 

Unless you are planning a perfectly timed mid-life crisis, let’s assume you are not going to live there and (unless you plan to live there at any point in the future), this is a business decision that has real risks. It is a time to let the head, not heart, dictate your decision. 

Your ideal property will be in good condition, well laid out and attractive to the type of tenants you want to attract. Ideally, it has good quality fixtures and fittings and is ready for tenants to move into. If you are looking for steady monthly income, with minimal effort, a doer-upper is not your ideal choice, unless you are buying to renovate and sell again at a profit. 

It is also wise to start small – if you are able to buy with cash, avoid debt as it just reduces your net earnings. Most people are not in that position though, so all the more reasons to buy the right kind of place. 

Think carefully about location and what tenants it will attract. Speak to other people who know the area. Schools and transport links will attract more reliable tenants and finding a property in an advantageous location is likely to result in longer tenancies. Dead time between tenancies is the enemy of steady monthly income and profit. 

Whilst some of this may sound a little scary, rental property continues to prove an excellent way to provide steady passive income. If you take the time to consider the additional costs and risks, then you may make the right choice and be reaping the rewards in no time! 

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All content is for informational purposes only and is the opinion of the author. Nothing on this website should be interpreted as "advice". Money Dashboard Ltd make no representations as to the accuracy, completeness, suitability or validity of any information on this site and will not be liable for any errors or omissions or any damages arising from its display or use.

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