In England and Wales, variable service charges paid by residential leaseholders are held on a statutory trust under section 42 of the Landlord and Tenant Act 1987, so they are not income of the landlord or management company that collects them. Interest earned on the money is taxed on the payee as trustee, but section 480 of the Income Tax Act 2007 takes it outside the 45% trust rate. Rent, ground rent and fixed charges that fall outside the trust remain ordinary taxable income.

What does section 42 actually do?

Section 42 applies where the tenants of two or more dwellings may be required under their leases to contribute to the same costs by paying service charges, and since amendment it also covers a single tenant who alone contributes to particular costs. The sums paid, any investments representing them and the income on them are held by “the payee” as a trust fund. The payee is the landlord or any other person to whom the charges are payable under the leases.

The trust has two layers. The fund is held first to pay the costs the service charges were collected for, and subject to that for the contributing tenants for the time being, in shares proportionate to their liabilities. A leaseholder who sells does not take a share with them; it stays in the fund. When the last lease ends, the fund is dissolved and passes to the landlord.

A service charge here takes its meaning from section 18 of the Landlord and Tenant Act 1985: an amount payable by a tenant of a dwelling, as part of or in addition to rent, for services, repairs, maintenance, insurance or the landlord’s costs of management, the whole or part of which varies or may vary according to the relevant costs. HMRC’s Trusts, Settlements and Estates Manual at TSEM5715 reduces this to a checklist. The trust exists only where:

  • the landlord is not an exempt landlord;
  • tenants of two or more dwellings must contribute under the terms of their leases;
  • the contributions are for repairs, maintenance and similar costs; and
  • the charges, or part of them, are variable.

Exempt landlords, listed in section 58 of the 1987 Act and reproduced at TSEM5745, include local authorities, registered social landlords and non profit registered providers of social housing. The Act applies to England and Wales only.

Is the landlord taxed on service charges it collects?

Not on money within section 42. PIM1075 says service charges and sinking fund contributions received by a flat management company fall outside corporation tax because the payee is not beneficially entitled to them; it receives them as trustee. ICAEW’s technical release TECH 03/11 records HMRC’s confirmation that, provided the trust terms are observed, receiving section 42 service charges does not create a tax liability for the payee. The same release says trust money does not belong to a residents’ management company or RTM company and should not be shown as its asset.

The position is different where the trust does not bite. TSEM5725 gives the example of a lease that fixes the rent and says part of it will be used for repairs: because the amount does not vary with the costs, it is not a service charge and the whole rent is property income of the landlord. Payments by freehold house owners under covenants are outside section 42 (TSEM5735), as are funds leaseholders set up voluntarily when their leases do not require it (TSEM5730). Section 42 also covers dwellings only.

Where a landlord’s receipts are taxable, PIM2040 explains that payments by tenants towards maintenance are taxable in full and the cost of the repairs is deducted in full. The two are not netted off, and the timing can differ because the repair may be done in a later period. GOV.UK’s guidance on rental income likewise counts charges for services such as cleaning communal areas, heating and repairs as rental income.

Who pays tax on interest earned on the fund?

The trustee does. TSEM5712 explains that a company receiving interest on service charges does so as trustee, so the interest is not within its corporation tax; trustees, whether individuals or companies, pay income tax instead. Banks have not deducted tax from trustees’ interest since 2016 to 2017.

Without special rules, section 42 would create an accumulation trust taxed at the trust rate, which section 9 of the Income Tax Act 2007 sets at 45%. Since 2007 to 2008, section 480(3)(c) of that Act excludes income from service charges paid in respect of UK dwellings and held on trust, so the special trust rates in section 479 do not apply. The exclusion extends to dwellings in Scotland and Northern Ireland, even though section 42 itself does not.

The interest is therefore taxed at the rates that would otherwise apply. For 2026 to 2027, GOV.UK shows trustees who are not charged at the trust rate, such as those of interest in possession trusts, paying 20% on income other than dividends. Under Finance Act 2026 the savings basic rate rises to 22% from 2027 to 2028.

A small fund may have nothing to report. From 6 April 2024, TSEM5710 says trusts with income of up to £500 do not report it to HMRC or pay tax on it. Above that, the full amount is taxable, not just the excess.

What does the trustee have to file?

Where taxable income arises, the trustee has the normal obligation to notify chargeability (TSEM5755) and report the income on a Trust and Estate Tax Return. TSEM5755 also explains that some flat management companies used to include this interest in their company tax returns, and that this is no longer appropriate where funds are held on trust. A company that has done so should move the interest to a trust return rather than continue the old practice.

What about funds that fall outside section 42?

TSEM5750 says the treatment depends on the structure chosen. An individual might hold the money as a trustee or as a maintenance contractor. A company might hold it as trustee or trade as a management company and pay corporation tax. An unincorporated residents’ association is liable to corporation tax unless it acts as trustee. A deliberately created trust can be a bare, interest in possession, discretionary or accumulation trust depending on its terms, although the section 480 exclusion still applies wherever the money is service charge money held on trust for UK dwellings.

Can a leaseholder who lets their flat deduct service charges?

Yes, in principle. GOV.UK’s list of allowable expenses for landlords includes ground rents and service charges. The usual capital rule still applies to what the money pays for: a contribution towards works that improve the building, rather than repair it, is capital. See capital versus revenue expenditure and allowable business expenses. The demand from the managing agent should show how much relates to the reserve or sinking fund, and that breakdown is worth keeping.

What does this look like in numbers?

Illustration only. Elm Court has 12 flats. The residents’ management company collects variable service charges under the leases and keeps a sinking fund of £60,000 in a designated trust account. In 2026 to 2027 the fund earns £1,800 interest.

  • The service charges themselves are not company income and are left out of its corporation tax computation.
  • The £1,800 is trust income. It is over £500, so all of it is taxable: £1,800 x 20% = £360, reported on a trust return by the company as trustee.
  • If the company also receives £2,000 a year from a telecoms operator for equipment on the roof, that belongs to the company itself and goes in its corporation tax return. See tax for residents’ management companies.

What are the common mistakes?

  • Putting sinking fund interest through the company’s corporation tax return.
  • Assuming every reserve is a section 42 trust. Fixed charges, freehold estate funds and voluntary funds need checking against the lease.
  • Paying tax at 45% on service charge interest when section 480 takes it out of the trust rate.
  • Paying only on the excess over £500 when the whole amount is taxable once the limit is passed.
  • Using one building’s fund to pay another building’s bills, which TECH 03/11 says is a breach of trust.

Leaseholders and landlords with wider letting questions may also find landlord mortgage interest relief useful.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.