Should the tax consequences of renting out a garden flat deter homeowners from earning some extra income? We weigh up the risks and rewards of residential rentals.
In an economy which is under significant pressure, more individuals are seeking ways to earn additional income by renting out property.
While the additional income is welcomed, there are tax consequences (both positive and negative) for the additional rental income earned. Where our tax laws are not properly applied, the renting of property may be seen to rather carry more risks than rewards. But is it really the case?
As soon as an individual (landlord) rents out a property and earns rent, this rental income is subject to being taxed. This is so whether the property takes the form of, for example, a holiday home, guesthouse or the sub-letting of only a part of a house. In the case of a landlord who is a tax resident in South Africa, all rental income earned abroad must also be disclosed to SARS.
The rental income earned by the landlord will then be added to any other taxable income earned by the landlord for the year of assessment in question. Not only the rental income will be subject to tax but also any other amounts earned by the landlord from the property rental (such as lease premiums paid upfront by a tenant).
When a landlord applies a deposit to, for example, repair any damage to the property rented, the deposit amount must also be disclosed to SARS as part of the rental income earned by the landlord.
Therefore, the total rental income earned from the property must be disclosed to SARS, regardless of whether there are expenses which can be claimed or are in fact claimed.
The (many) risks
Imprisonment, penalties and interest
Where the total rental income earned by the landlord is not fully disclosed to SARS, the landlord may face criminal prosecution, penalties and/or interest for the incorrect disclosure of information to SARS. If this is the case, the landlord should ensure that this position is corrected on an urgent basis with SARS through the Voluntary Disclosure Programme.
Increased taxable income
While the total rental income must be disclosed to SARS, the landlord’s ultimate taxable income (and therefore tax payable to SARS) may be reduced by the expenses incurred. These expenses may be claimed as a tax deduction, provided that the expenses are:
- Wholly incurred in the production of the rental income
- Not capital in nature
- Not of a private or domestic nature and are not for the maintenance of the landlord, his family or establishment
- Claimed in the correct year of assessment and that there is proof that such expenses were incurred by the landlord
Where expenses are claimed that do not comply with the above requirements, the landlord faces the risk of the expenses being disallowed as a deduction from taxable income, resulting in higher taxable income than anticipated.
It is also important to bear in mind that the proof of the expenses must not only be available at the time that the landlord’s income tax return is completed but must also be kept for a period of at least five years thereafter. This ensures that there is compliance with the Tax Administration Act, and also that the expenses are not disallowed by SARS if an audit or verification is done a number of years after the submission of the income tax return.
Where the whole property is not rented out (for example, where only one bedroom is rented to a tenant), the area which is leased must be divided by the total area of the whole property in order for an apportionment percentage to be calculated.
If an expense is incurred in respect of any remaining bedroom, this expense cannot be allowed as a deduction because it does not relate to the area which is rented out and cannot be said to be incurred in the production of rental income, for example.
If SARS discovers that an apportionment has not already been applied by the landlord, SARS will apply its own calculated apportionment ratio after adding penalties and interest. The landlord will then need to dispute this apportionment ratio (if it is not correct), which may take a substantial period of time to finalise.
Often, landlords are faced with a situation where their expenses exceed the income earned. This resultant loss is generally available to be set-off against other income earned by the landlord, unless the loss is ring-fenced.
Ring-fencing is a specific anti-avoidance mechanism used by SARS to ensure that the landlord is not merely using the rented property as a way to incur losses and reduce the tax payable. In order to prevent the ring-fencing provisions in the Income Tax Act from applying, the landlord must prove that she or he is conducting a bona fide trade. This is usually a very involved process and SARS is often reluctant for the ring-fencing provisions not to apply, due to the rental of residential accommodation being a suspect trade, for tax purposes.
Where all of the above risks are averted, the landlord can sleep well at night knowing that she or he has made additional income and is taxed solely on profit (after allowable and proven rental expenses have been deducted from the income).
The rewards can be substantial and, where our tax laws are applied correctly, the rewards outweigh the risks.
A general overview of our tax laws shows that there are many risks involved in renting out property. However, to the well-informed landlord who adheres to all tax law requirements, the rental of property becomes far less tedious and risky. Landlords are therefore always advised to seek thorough advice from a tax professional to ensure that they reap the just reward of renting out property.