Property Case Studies (Part 2) – Residential Property Conversions

Lee Sharpe looks at single-household residential property conversions into separate households.

In last month’s article, we looked at a couple of different scenarios for landlords buying new properties where the property was to be maintained in single-household occupancy.

This month, we shall look at scenarios where ‘ordinary’ single-household residential properties are being converted into use for separate households.

Fundamentals – alterations to the structural fabric of a property are likely capital

In the previous scenarios, when we looked at pre-letting expenditure, one of the key arguments to advance in a claim for tax relief against letting income is that the asset has not been improved overall, but has essentially been returned to its original state. A good recent case to illustrate this point is G Pratt & Sons v HMRC Commissioners [2011] UKFTT 416, which involved the reinstatement of a long private road to a dairy farm using modern materials. An older but likewise useful case is that of Conn v Robins Bros Ltd [1966] 43 TC 266, a summary of which can be found at HMRC’s Business Income manual at BIM35480. In each case the taxpayer won.

A particularly adventurous HMRC officer might be tempted to argue that the nature of the asset – the property – has fundamentally changed by converting it from a single household dwelling into separate living accommodation/dwellings and, as such, the extent of improvement means that all expenditure is capital. Helpfully, Conn v Robins Bros Ltd confirms that disallowable capital improvements and allowable repair costs can sit side by side in the same overall project. Where costs can reasonably be split between disallowable capital improvements and allowable maintenance or repairs, then the improvement element does NOT make everything capital.

This is echoed in HMRC’s Property Income manual at PIM2020, under ‘Extensive alterations to a property’ and ‘Capital work and revenue repairs at the same time’.

Trap :

Don’t assume that, just because an expense is essential – even if required by law – that it must be allowable. If something has to be improved, etc., to a higher standard than before, then it may be capital expenditure.

Case Study 3:

Converting a large residence into a house in multiple occupancy

Joe acquires a large 3-storey 4-bedroom Victorian semi-detached house which is of sufficient scale that he can realistically turn it into a ‘house in multiple occupancy’ (HMO) for six occupiers. Joe has allocated some of his main costs below:

Work	Cost (£)	Revenue (£)	Capital (£)
Partitioning the largest bedroom on each of the first and second floors to get two extra bedrooms	3,500	-	3,500
Upgrading fire safety system throughout the building, over and above residential use, required in order to secure HMO licence	5,000	-	5,000
Rewiring the property, which includes the addition of several new power and lighting points	6,000	4,500	1,500
Washing facilities in each room –required for HMO licence (but replacing in two bedrooms, which already had ensuite facilities)	2,500	800	1,700
While the upper two floors helpfully already had bathrooms, Joe adds additional toilet facilities by extending and partitioning off existing bathrooms	2,000	-	2,000
Re-fitting the kitchen and adding extra cupboard space, cooking and refrigeration facilities	5,000	3,500	1,500
Structural repairs	3,000	3,000	-
Redecorating and plastering throughout	8,000	7,000	1,000

TOTALS	35,000	18,800	16,200

Points to note:

Clearly, creating additional bedrooms or toilet facilities is going to be capital expenditure, as would extending the property.

In this case study, the local authority has demanded that an inherently superior fire safety system be installed throughout the building, even down to the fire-rating of the cabling. Even so, it is not an allowable expense but an improvement, because it is of a higher standard than it would need to be for an ordinary residence and cannot therefore be ‘replacing like with like’.

The electrical re-wiring, on the other hand, has no special requirements imposed due to the property being an HMO. Although it will almost certainly be superior to the wiring system it replaces, it is to the same modern-day equivalent ‘standard’ as the old wiring. The cost has been split between replacement components, and the capital additional parts, sockets and fittings in the various rooms.

Likewise, the kitchen is to be of a similar standard as the one it replaced – when it was new. However, the extra cupboards, fridge and cooker, etc., will be disallowable capital.

Re-decorating and plastering has been apportioned on a reasonable basis between work on the additional rooms and the rest of the property.

Joe could claim capital allowances (including the 100% annual investment allowance) on capital expenditure on ‘plant and machinery’ located outside of dwellings. This definition would include heating, lighting, fire safety systems, and similar. A temporary change in HMRC’s interpretation of ‘dwellings’ meant that, for roughly a couple of years up to October 2010, expenditure incurred on communal kitchens, bathrooms and lounge areas in HMOs could be eligible for capital allowances. But such areas are now basically considered to have become part of the dwelling-space again, so expenditure now will not qualify for capital allowances, except perhaps in some non-dwelling areas such as communal entrances, stairwells, and similar (HMRC Brief 45/10).

Case Study 4: Conversion into apartments

Valerie has acquired the adjoining property to Joe: she doesn’t fancy the additional hassle of running HMOs and instead converts her property into three separate two-bedroom flats with kitchen-diners. Her project requires structural work to each floor, although she sensibly keeps kitchen and bathroom facilities in the same location where she can. She also installs a small lift to make the upper floor more accessible.

Work	Cost (£)	Revenue (£)	Capital (£)
Structural alterations	10,000	-	10,000
Re-wiring – including separate meters	8,000	3,000	5,000
Replacement (to a similar standard) and additional kitchens and bathrooms	16,000	4,000	12,000
Redecorating / plastering throughout	8,000	4,000	4,000
Lift installation	15,000	-	15,000

TOTALS	57,000	11,000	46,000

Points to note

Perhaps unsurprisingly, since less is left of the original property than in Joe’s conversion, Valerie’s project costs are more capital-oriented.

Valerie may also be able to claim capital allowances on the retro-fitted lift in the stairwell, and the electricity meters if they are not inside the separate dwellings, as well as heating, lighting and electrical wiring and fixtures in those communal areas.

VAT and changing the number of dwellings

Both Joe and Valerie may well be eligible to be charged just 5% VAT on construction services on their respective conversions, undertaken by VAT-registered tradesmen. This would include materials paid for as part of works but not materials paid for separately. Particular care is needed with HMOs.

Conclusion:

It is understandable that full-blown property conversions are likely to be more expensive and to include more capital costs, which (aside from capital allowances) cannot immediately be recovered. But using the rules for apportionment can still secure valuable tax relief against letting profits. Even in HMOs, it is possible to secure a useful claim for capital allowances in the non-dwelling areas.

It is essential to keep a good record of those otherwise unclaimable capital costs so that they can be claimed when the property is sold, rather than being completely wasted.