Alan Pink considers some of the commonest errors (in both directions) in landlords’ expense claims.
When the UK introduced self-assessment for tax purposes in 1996, the Inland Revenue (as they then were) – all credit to them – made an effort to simplify our byzantine system, and one of the beneficiaries of this was the property owner who lets out a rental property as an investment.
However, there are still many common misunderstandings of what the tax rules are, and sometimes landlords aren’t claiming everything that they are due.
Let’s have a look at some of the more common problem areas.
Repairs or capital?
Here’s an excellent example of a rule that is easy to state in words, but not at all easy to apply in practice.
The rule is that repair expenditure is validly claimable against your rents, but capital expenditure, which improves the property, isn’t allowable. Apart from rare and specific exceptions like replacement double glazed windows as opposed to the old single glazed ones, if the effect of the work you do on the property is to improve it, this becomes a capital expense, relievable ultimately against your capital gains tax when you sell the property (provided the improvement is still in situ at the time), but is not available to offset against the rents now.
A lot of landlords find this difficult to understand, and even difficult to accept, given that they can have a large tax liability when, in cashflow terms, they’ve made no profit. But this is definitely an area in HMRC’s sights when enquiring into landlords’ tax returns.
By definition, it’s very difficult to set out easy and briefly expressed rules of thumb. But the following example may give a flavour of the difference.
Example 1: A tale of two flats
George acquires a building, which is laid out in two flats, Flats One and Two. Flat One is empty, and he takes advantage of this to basically gut the place. He rips out the antiquated bathroom and kitchen fittings and replaces them with brand spanking new ones, aimed at attracting a much higher rent. At the same time, he gives the whole apartment a lick of paint and replaces the carpets.
The expenditure on the beautiful new bathroom and kitchen fittings is capital and, therefore, disallowable, and the new carpets, similarly, probably won’t be claimable (see the section on replacement relief below). It would be a hard-hearted HMRC officer, however, who would disallow the cost of repainting the flat.
Flat Two is in a completely different situation because it is tenanted, and George doesn’t want to give the tenant notice. So, he works around the tenant, so to speak, gradually replacing worn-out work surfaces, taps, etc.
This has much more the flavour of repair work, especially if it takes place over a period after the property has been acquired, and this should probably be treated as validly claimable against rents.
The truth of the matter is that this is one of those areas that is very much subject to vague ‘impression’ rather than clearly understandable rules. But bear in mind that the timing of repair expenditure can make a difference, as it may well have done in the example of Flats One and Two above.
Other capital expenditure
Property improvement isn’t the only type of expenditure that’s disallowable as ‘capital’. For example, legal costs of buying and selling properties are often wrongly claimed against the rents; but these are actually related to the purchase and sale transactions and should, therefore, be claimed for capital gains tax purposes rather than against income tax. The same applies to costs such as stamp duty land tax and land registry fees.
Again, HMRC is quite hot on picking up expenditure of this type when they enquire into returns; finding capital expenditure that has been claimed in the rental statement is likely to be their first target in pursuing any such investigation.
Expenditure covered by deposit
Although the use that landlords can make of tenants’ deposits has been very much circumscribed by recently legal changes, a departing tenant who has absolutely trashed the place can expect to have sums deducted from the initial deposit he had to lodge with the letting agent before he first moved in.
Let’s look at a scenario to illustrate how this could easily lead to an error in the landlord’s tax return:
Example 2: Retained deposit
Agnes lets out her investment flat to Peter, who seems like a nice boy. Peter lodges a deposit with Agnes’s letting agent of £5,000, and moves in.
When Peter leaves six months later, Agnes visits the flat and sees to her horror that the whole ceiling has collapsed. Further investigation reveals that Peter has broken a hatch through into the loft above the flat and installed sprinkling machines to keep his luxuriant crop of plants well-watered. Going away on holiday, he forgets to turn the sprinklers off, and the result is a massive flood that basically ruins the flat.
When Agnes sends her papers in to the accountant to do her tax return for the year, she sends all the invoices for the repair work, but forgets to tell the accountant that some of the expenditure has been covered by holding on to Peter’s deposit. Because £5,000 of the expenditure is covered by this deposit, it can’t be claimed as an expense, because, to this extent, Agnes can’t be said to have incurred the expenditure.
The ‘Osborne tax’
Otherwise known as ‘Clause 24’, or ‘Section 24’, most readers won’t need to be reminded that this recent change in the tax rules comprises a disallowance of part of the interest paid on loans taken out in respect of buy-to-let properties.
For the 2018/19 year (i.e. the tax returns for which were still being done at the time of writing), the rate of disallowance is 50%, but the way the mechanics of the Osborne tax work is to disallow the relevant proportion (i.e. 50% for 2018/19) in the first stage of the computation, and then bring back a 20% (basic rate) allowance lower down in the calculation. I suspect that many people have not yet caught onto the subtilties of this and will be claiming interest as a deduction in full in the old way – despite the fact that the tax return format leads you in the right direction.
Wear and tear allowance
Again, the tax return doesn’t have a box for claimable wear and tear allowance any more, but this may not stop everyone from claiming it based on prior years. Wear and tear allowance was basically a rough and ready way of claiming for the cost of furnishing a residential property, and keeping that furnishing in good nick by replacing items when necessary. It was worked out broadly as 10% of rents received, and this was allowed regardless of how much (if any) expenditure had actually been laid out on furniture.
This relief was abolished with effect from 6 April 2016, and now we have a different relief called ‘replacement relief’ to do the same basic job.
Replacement relief applies to ‘domestic items’ such as furniture, appliances like fridges and freezers, and crockery – but does not apply to fixtures like boilers and central heating systems. The way the rules work is that you can claim the cost of replacing such items, but you can’t claim the initial cost of acquiring them in the first place.
This is definitely an area where I suspect that valid claims by landlords are being missed. For example, a new three-piece-suite is a piece of expenditure that it is hoped will last for many years and, therefore, has the look of ‘capital’ expenditure, which might put many claimants off. However, under replacement relief the full amount is claimable, providing it doesn’t constitute an improvement over what was there before. So, a Chippendale dining table, for example, replacing one from Ikea, will not be eligible for a full claim, but only to the extent that the Ikea table would have cost something to replace.
Practical tips
The timing of refurbishment work on your property can make a difference as to whether it is claimable against tax. Gradual piecemeal work is more likely to be allowable than a radical gutting and replacement of interiors:
• Don’t forget to retain a long-term record of expenditure that is capital and, therefore, disallowable against rents. This record will provide you with the numbers, and the evidence, for claiming a reduction in your capital gains tax when the property is ultimately sold.
• Don’t forget that replacement relief is available for furniture, appliances, etc., and can make a big hole in your taxable rental profits in the year you incur the expenditure, even though the items concerned may be set to last for several years.
