How rental income tax may hurt real estate investment
By : CPA Prosper Ahabwe
Many Ugandans aspire to own property in the real estate sector. Some desire to own a residential home or earn rental income. If the purpose of the house is to reside in it for a home, such property does not generate income. Where the property is used to generate income in the form of rent by leasing or letting it out to tenants, there would be a taxable activity and incomes arising therefrom would be subject to rental income tax.
Rent is any payment, including a premium or like amount made as consideration for the use or occupation of, or the right to use or occupy, land and building. Persons who lease or let out land or buildings are, therefore, said to be earning rent.
Rental income is taxed separately from the business income of a company or individual. A person who earns rental income is granted deductions for expenses incurred in respect of the property to arrive at the rental income subject to rental tax at the applicable rates.
Over the past three years, there have been several amendments to the Income Tax Act targeted at restricting the extent to which expenses may be deducted by a person and altering the tax rates that apply to rental income in a year. Below, I highlight their implications on two kinds of landlords; companies and individuals:
Before 1 July 2021, to arrive at the rental income subject to tax for an individual, the following deductions were allowable against the individual's rental income.
20% of the rental income as expenditure incurred by the individual in the production of such income. The individual was deemed to have spent 20% of his rental income as expenses although the actual expenses may have been lower or higher than 20% of his income.
Interest incurred on mortgage from a financial institution.
Following the above deductions, a tax rate of 20% was applied to the individual's chargeable rental income in excess of UGX 2,820,000. An individual earning rental income less than UGX 2,820,000 paid nil rental tax.
For a company, all expenses incurred in the production of the rental income were allowable deductions except those specifically excluded such as entertainment or private-in-nature costs. If the building was for commercial purposes excluding residential accommodation, the company would annually enjoy a commercial building deduction of 5% of the cost of construction or acquiring the building excluding land. Where assessed tax losses arose, the same would be carried forward to offset against future taxable rental incomes. The company's chargeable rental income would then be subjected to tax at a rate of 30%.
Between 1 July 2021 and 30 June 2022, the following deductions were allowable against the individual's rental income:
75% of the rental income was treated as expenditure and losses incurred by a person in the production of such income, subject to verification by the Uganda Revenue Authority.
The wording of the Income Tax Act (ITA) suggests that an individual was deemed to have incurred expenses equivalent to 75% of the rental income earned.
The individual's resultant chargeable rental income was then subject to tax at a rate of 30%.
Whereas a company was allowed a deduction for expenditure and losses incurred in the production of rent under the provisions of the Income Tax Act, implying that the actual expenses incurred by the company are entirely deductible without a limiting cap. However, it is also argued that the provision that deems 75% of the rental income to be treated as expenditure and losses incurred by a person may also apply to a company.
The company's resultant chargeable rental income was then subject to tax at a rate of 30%.
Currently and effective 1 July 2022, the rental tax regime was simplified for individuals, by excluding deductions of any expenses incurred while the tax rate was reduced from 30% to 1 2%. Individuals are only allowed a non-taxable threshold rental income of UGX 2,820,000 and the excess rental income is taxed at a rate of 1 2%. In the case of a company, it would be allowed a deduction for expenditure and losses incurred up to a cap of 50% of its rent. Thus, where its expenses exceed 50% of the rental income the allowable deduction shall be 50% of the rental income for that year. Companies remained taxed at a rate of 30%.
To consider the impact of the current legislation above in an example, assuming a company or individual incurred UGX 1 billion to construct a commercial building. Upon completion, the building was immediately put up for rent and earned rent of UGX 200 million in a year. During the same year, the following costs were incurred - mortgage interest UGX 90 million, repair and maintenance costs UGX 10 million, and broker Commissions UGX 10 million. The table below summarizes the impact of the changing legislation on the rental tax cost of an individual or a company:
The above tax legislative changes create uncertainty for investors in the real estate sector as the tax rates or what constitutes deductible expenses have drastically changed resulting in increased rental tax costs by 33% on companies and by 76% on individuals between periods prior to 1 July 2021 and those after 1 July 2022. Companies continue to shoulder a disproportionately higher rental tax burden in absolute tax terms for the same level of rental income earned by an individual due to the higher tax rate of 30% and 50% cap on deductible expenses. In addition, upon distribution of profits or payment of dividends by a company to its shareholders, an additional 15% withholding tax would apply on the dividends. This may discourage investment in the real estate sector using a company as an investment vehicle.
Individuals and companies doing the same real estate business with similar investments should be treated equitably for rental tax purposes such that the mode of taxing rental income earned from different investment vehicles does not influence the investor's choice of whether to invest in the real estate sector as an individual or through a company. To achieve this, there is a need to review the current rental income tax regime, especially for companies vis-a-vis individuals. Attention may be given to increasing the cap on the allowable deduction to over 65% of rental income or reducing the tax rate to about 19% or a combination of both to achieve an effective tax rate that is similar for individuals and companies.
Investors desire stability in tax regimes to determine the relative attractiveness of a sector to invest in, as taxes can affect the return on investment and duration within which an investor expects to recoup their initial investment capital. Therefore, tax policy formulators should minimise the frequency of changes in the rental income tax regime to create more stability for the real estate sector. It is advisable to seek tax advice from your tax advisor when making capital investments in the real estate sector or support to comply with rental income tax rules on an ongoing basis.
CPA Prosper Ahabwe
Associate Director. Tax - Ernst & Young Uganda
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