The Rent-A-Room exemption allows people letting part of their only or main home as furnished accommodation to a lodger or flatmate to receive rent of up to £7,500 per annum (£4,250 up to 5 April 2016). If the property is owned jointly, each owner is entitled to claim £3,750 each. If your rent is higher than this, the first £7,500 (or £3,750 for joint owners) will be tax free.
An important point to bear in mind with the Rent-a-Room exemption is that it only applies to residential accommodation. Sadly, you cannot use it to let an office in your house to a limited company, whether it is your own or somebody else's. However, there is nothing to stop you putting a desk or other office furniture in the room or rooms you are letting provided that they are for the use of the lodger and the accommodation is let principally for residential purposes.
The requirement that the property must also be your own (or main) home means that you must actually live in the same building yourself in order to qualify for the Rent-a-Room exemption. It therefore excludes separate properties such as buy-to-lets or granny flats. The accommodation you are letting must also be furnished, which will tend to exclude cupboards, sheds, greenhouses, coal bunkers and clothes lines for down-and-outs. Therefore, if the 18th century tradition of keeping a hermit at the bottom of your garden ever comes back into fashion, it would probably not qualify for the Rent-a-Room exemption!
Houses converted into flats do not qualify for the exemption as the accommodation must not be self-contained. However, if you run a bed-and-breakfast or a guesthouse you can still qualify for the exemption although you must declare it on the Self-Employment pages of your tax return rather than the UK Property pages. Incidentally, the live-in requirement is not the same as the property being your principal private residence. You generally have a bit more choice about that if you own more than one property. You can also use the exemption if you do not actually own the property but only rent it, although you would probably be obliged to inform the landlord.
The only downside to the Rent-a-Room exemption is that you cannot claim any expenses against the rent, even if your gross rent exceeds the tax free threshold. This will not be an issue if your gross rent is below the threshold. However, if your gross rent is well above the threshold or you have a high proportion of allowable expenses that you would otherwise be able to claim, it may be advisable not to use the exemption and pay tax in the normal way instead. It is worth noting that you can still deduct losses from earlier years even if you claim the exemption. This can be handy if you incurred many start-up expenses and made a loss in the first year (in which case you would have opted out of the exemption) and then received rents above the threshold in subsequent years with much lower expenses (when the exemption would be beneficial).
The Rent-a-Room exemption is automatic if your gross rental income from such lettings is below the annual exemption and you do not receive a tax return. If your gross rent exceeds £7,500 (from 6 April 2016). per annum, you should tick Box 4 on page UKP1 in your tax return. Likewise, you can opt out of the exemption simply by not ticking Box 4. However, if you wish to opt back in or out of the exemption at a later date, you must inform your tax office within the specified time limit, unless gross rent falls below £7,500 (from 6 April 2016). per annum in which case the exemption will automatically apply again. The specified time limit is 22 months minus 5 days after the end of the tax year. This is equivalent to the usual limit of one year after the filing deadline for amending a personal tax return. In other words, you must tell them by 31st January of the year after next following the end of the tax year, although they are empowered to extend this in certain cases such as sickness, absence abroad or serious personal difficulties.
There appears to be nothing in the legislation to prevent the Rent-a-Room exemption being used for connected persons such as family members, so if your son or daughter pays you house-keeping money this is not subject to tax unless it exceeds the exempt amount - and even then only to the extent that it exceeds the cost of household expenditure (anything less can be treated as a contribution to the family budget rather than rental income).
Finally, it should be noted that the Rent-a-Room exemption only applies to income tax, not capital gains tax. If you let part of your house to a lodger and later sell the property, your principal private residence relief may be restricted according to the proportion of the property let and the time you have been letting it, (although you would be entitled to Letting Relief which may well eliminate any taxable gain). This would not apply if you only have one lodger at a time, but could do if you have more than one, depending on the extent to which you are deemed to be running a lodgings business.