Beware pitfalls of buy-to-let

People contemplating buying a property to let as an alternative to investing in a pension should think again. The recent 'Safe as Houses' report published by the Prudential predicts 'a significant fall in property prices in certain areas of the country' and also claims that the cost of maintaining property is 'set to rise dramatically'.

But even if these predictions - together with the view of Andrew Clare, Financial Economist at Legal & General, that equities will outperform residential property over the next 10 years or so - prove unfounded, there is still the issue of tax to consider.

Money invested in a pension benefits from having tax relief added to it, and also grows virtually tax-free. This is not the case with buy-to-let investments. It may be possible to avoid stamp duty by buying a property for less than £60,000 - or less than £150,000 if you are buying a property in an area designated by the Inland Revenue as 'disadvantaged' - but there is little you can do to avoid your liability to income tax on the income you get in rent, and capital gains tax when you eventually sell the property.

Keeping quiet is not an option: you have a duty to tell the Revenue about any sources of untaxed income within six months of the end of the tax year in which you started receiving the income.

The same is true of any capital gains you may make. If you don't and are found out - you're picked for one of the Inland Revenue 's random self-assessment inquiries, for example, or a disgruntled tenant shops you (which is not uncommon, according to a Revenue spokeswoman) - you face possible penalties and certain interest on any tax owing.

The good news is that you are unlikely to have to pay tax on all the income from your 'rental business' - as the Revenue refers to buy-to-let investment - because of the expenses you can deduct in arriving at your taxable profit.

Providing they are incurred 'wholly and exclusively' in letting the property, and providing you keep accurate records of them, the kind of expenses you can claim include:

· the cost of repairs and maintenance of the property (but not the cost of improvements or alterations - although you may be able to use the cost of improvements to reduce your capital gains tax bill);

· interest on a mortgage or other loan used to purchase the property together with any fees charged by your lender;

· utility bills and council tax that you, rather than your tenants, pay;

· buildings and contents insurance - but not premiums for life insurance taken out to repay the loan in the event of your death;

· fees paid to letting agents, legal fees paid to have tenants evicted and accountancy fees if you choose not to fill in your own tax return;

· the cost of advertising the property as well as incidental costs, such as stationery, involved in letting the property.;

If you let furnished property, you can also claim a deduction for the cost of renewing and replacing carpets, furniture and so on. You can either claim the actual cost (less anything you get for selling the old item) of replacing something or you can claim a yearly '10 per cent wear and tear allowance' which is equal to 10 per cent of the rent you receive.

Ajay Ahuja, author of The Buy-to-Let Bible, always recommends deducting 10 per cent of the rent on the grounds that, because you claim it yearly, it's likely to be higher than claiming the replacement cost.

What you can't deduct from rental income when calculating your taxable profits are the costs involved in buying and selling the property. However, you should keep records of what you paid the estate agent, surveyor and conveyancer because you can use these costs to reduce your capital gains tax bill.

This is also true of the costs of major improve ments to the property that helped to increase its value.

Holding on to your buy-to-let property for at least three years also helps to reduce your capital gains tax bill because of 'taper relief'. This reduces the percentage of any gain you make that is taxed in line with the num ber of years you owned an asset.

Check whether a property you are thinking of buying - whether to let or live in - is in a 'designated disadvantaged' area by entering its postcode in the Disadvantaged Areas Relief: Postcode Search section of the Stamp Office website.

Detailed information on the expenses you can claim against income in the free Inland Revenue booklet 'IR150 Taxation of rents: A guide to property income' is available to download at www.inlandrevenue.gov.uk or by phoning the self-assessment order line on 0845 900 0404.

· The Buy-to-let Bible (£11.99) is published by Law Pack Publishing.