As a landlord you can prepare your tax accounts either on a cash basis or using the normal accounting rules (the accruals basis). If you change methods you must make transitional adjustments.
What’s involved?
Cash or accruals accounting
Business accounts are usually prepared on an accruals basis, that means they reflect income and expenses for the accounting period. By comparison, the cash basis only reflects income received and expenses paid in the accounting period. Normally, HMRC expects accounts to be prepared using the accruals basis but since April 2017 property rental businesses owned by individuals or partnerships which receive income of £150,000 or less per tax year must use the cash basis unless they elect not to.
Trap. If you switch from one accounting basis to the other because you cross the £150,000 limit, or elect not to use the accruals basis, the legislation requires you to make a transitional adjustment.
Accruals to cash basis
A cash-to-earnings-basis adjustment (or vice versa) is needed to prevent income or expenses escaping tax or being taxed twice. The adjustment for accruals to cash basis is straightforward. You simply bring into the first accounts that follow the change any transactions which occurred while using the accruals basis but weren’t reflected in those accounts.
Example. Sally owns and lets a retail shop and the residential flat above it. She had been using the accruals basis but is reverting to the cash basis for 2019/20. On 1 March 2019 Sally paid £800 for insurance which covered the next twelve months. As the accruals basis applied, only the cost of insurance to the end of the accounting period (5 April 2019) was included as an expense, e.g. £67 (£800/12). In the 2019/20 cash basis accounts Sally can deduct the balance of £733 plus any insurance she pays up to 5 April 2020.
Cash to accruals basis
Where you switch from the cash to accruals basis, you need to make a three-step calculation to work out the adjustment:
Add up income you are owed which relates to a period covered by cash basis accounts.
Add up income received in a period covered by your cash accounts but which relates to a period covered by the accruals basis. Add to this any amounts you owed to suppliers at the end of the last cash basis period.
Deduct the result of Step 2 from that for Step 1.
If the result of Step 3 is negative you can deduct it as an expense in your first accounts following the switch to the accrual basis. If the result is positive it must be taxed as income, but not all at once.
Tip 1. Whereas you get a tax deduction for the full amount of a negative adjustment, you can choose to spread a taxable positive adjustment over six years. For example, if you switched from the cash basis in 2018/19 to accruals for 2019/20 and Step 3 produced a positive amount of £2,400, only £400 of this would have to be taxed in 2019/20 and each of the following five years.
Tip 2. You can elect to accelerate an adjustment charge. You might want to do this if you expect the rate of income tax you’ll pay to be higher in later years (see The next step ).
* When switching from accruals to the cash basis simply bring in all income received and expenses paid that have been reflected in previous accounts. When switching the other way, follow the three-step calculation the legislation requires. If it results in a positive figure you can choose to spread the tax on it over six years.