The first article set out the basics, and made the case that ‘revenue’ is better than ‘capital’, but there are two principles to bear in mind.
We are, of course, discussing property investment businesses: many of the expenses that are capital in nature for a normal property (investment) business would in fact be revenue costs for a property development business, whose objective is to sell the underlying asset anyway.
And one further caveat: some landlords are finding that their finance costs alone are more than the rental income that the current rental market will bear, so the business is already making losses. If there’s no expectation of getting back into profit, but a reasonable prospect of selling the property for a gain, then capital treatment may in fact be preferred.
Property Repairs
Property repairs are probably the most contentious area of the ‘capital/revenue divide’ for rental businesses. One issue in particular is the concept of ‘improvements’: where there is an element of improvement then HMRC will usually argue that the expenditure is capital and cannot be set against income. Generally speaking, this is correct: for instance, adding an extra bedroom to a property would be a capital improvement – a useful indicator being that it would significantly improve the property’s re-sale value.
Here again, many new landlords might incorrectly assume that if the expenditure had to be incurred in order to let the property, then it should be deductible. In fact, HMRC may use that same point to argue that if the property couldn’t be let otherwise, then the work must be an improvement and therefore must be capital!
But it could be argued that almost any amount of expenditure would result in some degree of improvement, so how does this rule work in practice?
Let’s consider this in more detail in a common scenario where an investor buys a property and decides it needs ‘a bit of work’ before it’s ready for the lettings market.
Example
Jennifer buys a residential property which had previously been owner-occupied for £180,000. Her estate agent estimates that the property can yield up to £1,000 per month but recommends that she replaces some of the old single-glazed windows, and the kitchen, and Jennifer thinks the house needs re-decorating throughout, and a couple of carpets need replacing.
Jennifer’s surveyor also identifies that the wiring, whilst acceptable for an owner-occupier, might not be up to the standard required for rental properties. Finally, the property currently uses old electric storage heaters, which can be expensive to run.
Jennifer decides that it will be easier to deal with all of these costs together now, before trying to advertise the property to a competitive rental market.
She is faced with the following costs:
Replacement windows £5,000
New kitchen units £2,500
New carpets £1,500
Wiring overhaul £3,000
Central heating system £4,000
Re-decoration throughout £3,500
Total Cost £19,500
Even ignoring any mortgage interest, it will probably take at least two years before the net rental income covers all of this extra expenditure – and Jennifer hasn’t even let the property yet. She is worried that HMRC will reject this expenditure as capital and she will pay tax on those two years’ rental income despite this additional expense.
What Do HMRC Consider?
HMRC will often look at significant expenditure incurred before first letting, and be inclined to treat it as capital expenditure on improvements – perhaps by using the above argument that it couldn’t be let otherwise.
In fact, HMRC’s own manuals have guidance on this point. The Property Income Manual states:
“A landlord is most likely to incur capital expenditure before a property is let for the first time or between lettings.”
But it also goes on to say:
“Repairs to reinstate a worn or dilapidated asset are usually deductible as revenue expenditure. The mere fact that the taxpayer bought the asset not long before the repairs are made does not in itself make the repair a capital expense. But a change of ownership combined with one or more additional factors may mean the expenditure is capital. Examples of such factors are:
• A property acquired that wasn’t in a fit state for use in the business until the repairs had been carried out or that couldn’t continue to be let without repairs being made shortly after acquisition.
• The price paid for the property was substantially reduced because of its dilapidated state. A deduction isn’t denied where the purchase price merely reflects the reduced value of the asset due to normal wear and tear (for example, between normal exterior painting cycles). This is so even if the taxpayer makes the repairs just after they acquire the asset...”
Jennifer may still be concerned that HMRC could see the extent or cost of the works as evidence that the property wasn’t initially in a fit state to be let, or that its price had been reduced in recognition of the amount of work involved, and refuse a revenue deduction.
But Don’t Worry...!
Jennifer should be reassured, however, from the following extract from HMRC’s Business Income Manual (BIM35450):
“...If you would have treated the repairs as revenue if ownership had not changed, the repairs are normally revenue when expended by the new owner.”
Remember that property letting is a business for tax purposes, and it is acceptable to make use of the Business Income Manual where it suits.
Making Repairs to Occupied Property
Of course, it can be difficult to make significant repairs to a property whilst in occupation – but that doesn’t mean they aren’t repairs, just because they might preferably be undertaken whilst the property is empty.
The property was clearly habitable before Jennifer bought it, and therefore it could be let, and she should resist any argument by HMRC that the scale of costs implies capital expenditure, unless there is evidence – say from the vending agent or the surveyor – which indicates that the property would have commanded a significantly higher sale price under normal conditions.
Replacement Windows – Using Modern Materials or Construction Techniques
HMRC used to say that double-glazed windows were a capital improvement over single-glazed windows. However, more recently, they have accepted that double-glazed windows are now ‘industry standard’.
This raises another important point: where any improvement is a result of using modern materials or construction practices, it can be ignored provided that the underlying intention is ‘to replace like with like’ – more broadly, that improvement was incidental, rather than intentional.
Again, whilst HMRC’s Property Income Manual restricts its advice just to using modern materials, the Business Income Manual broadly confirms at BIM35460 (http://www.hmrc.gov.uk/manuals/bimmanual/bim35460.htm) that improvements from employing modern building practices and techniques may also be accepted as revenue.
Double-glazing is a useful example because it is still accepted as revenue despite providing significant improvements in terms of energy efficiency over single-glazed windows. But Jennifer should take care that she doesn’t assume that any double-glazing unit will be treated as a repair – replacing original softwood window frames with expensive, high-quality hardwood frames might still be challenged as a capital improvement.
Practical Tip
So far, Jennifer should be encouraged that she should get tax relief for at least some of her expenditure. In the next article, we’ll look at the rest of the example to consider how asset replacement and apportioning expenditure might work in a property business.
By Lee Sharpe
