Mr Toad is short of money and Ratty has suggested that he rent out a furnished room at Toad Hall. Ratty has an old friend coming to the village who might be interested. Having a lodger might help to deter the weasels living in the Wild Wood who had tried to take over Toad Hall last year.

Toad’s accountant suggests Toad might take advantage of ‘rent a room’ relief.¹ Toad would qualify, as he is an owner-occupier and Toad Hall is his main home. Toad will not need to include the rental income on his self-assessment tax return provided the gross amount received does not exceed GBP4,250 (before deducting expenses and including amounts paid for providing meals, goods and services, such as cleaning or laundry). The rental income will be entirely exempt from income tax. If his gross receipts exceed GBP4,250, he will need to consider the best way to declare the income.

There are two ways Toad can work out the tax if rental receipts exceed the threshold of GBP4,250. He can choose between paying income tax on either:

(i) The profit he makes from the letting, worked out in the usual way for a rental business (i.e. rents received minus expenses). This is the ‘rental business’ method.

(ii) The gross amount of his receipts (including receipts for related services he provides), minus the GBP4,250 threshold. In this case there will be no deduction for expenses or capital allowances. This is the ‘rent a room’ method.

If receipts exceed GBP4,250, Toad must inform HMRC if he wants to use the rent- a-room method (ii) above, or else (i) will apply automatically. The following examples illustrate where each option is better.

Toad lets out one of the rooms at Toad Hall for GBP150 a week. Total receipts for the year are GBP7,800. He is not exempt from tax because his gross receipts exceed the rent-a-room exemption of GBP4,250. He has expenses of GBP1,200, so his profit is GBP6,600. His gross receipts exceed GBP4,250 by GBP3,550 (i.e. GBP7,800 minus GBP4,250).

Using rent-a-room relief, Toad would pay tax on a profit of GBP3,550.

Using the rental business route, Toad would pay tax on his actual profit of GBP6,600.

In this case, rent-a-room relief is better for Toad.

Toad lets out a room at Toad Hall for a rent of GBP150 a week plus contributions for heating and light. His total letting receipts for the year from letting the room are GBP7,800 plus GBP200 for light and heating: GBP8,000.

Toad has expenses of GBP4,500, so his profit is GBP3,500. His gross receipts exceed GBP4,250 by GBP3,750 (GBP8,000 minus GBP4,250).

Using the rental business taxation route, Toad would pay tax on his actual profit of GBP3,500.

Using rent-a-room relief, Toad would pay tax on a profit of GBP3,750.

In this case, the rental business method is better.

Toad can change from one method to another from year to year, but must tell HMRC by 31 January following the end of the tax year in question. Rent-a-room relief will automatically apply if the rent drops below the threshold of GBP4,250.

Losses cannot be claimed under the rent-a-room scheme. Losses can be used only if Toad opts for the rental business method.

If Toad occupied Toad Hall as a leaseholder rather than as an owner-occupier, he would need to check whether his lease allows him to take in lodgers. If Toad owned Toad Hall jointly with another person also entitled to the rental income, the exemption limit of GBP4,250 would be reduced to GBP2,125 for each of them. He should also check that his insurance company will continue to provide cover. Toad currently has no mortgage, but if he had, he would need to confirm with the lender that he can take in a lodger. Letting more than one furnished room may amount to a trade, particularly if material services are provided. Even if rent-a-room relief can be claimed, using part of the home for a trade or business is likely to restrict principal private residence (PPR) relief from capital gains tax on a future sale.² Lettings relief, however, may be available.³ Where rent-a-room relief applies and the rental does not amount to a trade or business, PPR relief is not affected.