Lee Sharpe considers the tax implications for adapting a property for designation as a house in multiple occupation.
We shall use a case study to illustrate some of the key principles to consider when taking a property into a letting business, and in particular, where adapting an ordinary dwelling into an house in multiple occupation (HMO).
Case study: Yasmin
Yasmin is an established BTL property investor. She acquires the freehold in a substantial single dwelling-house, with four bedrooms, from its former owner-occupier. Let us say that the property cost £850,000, harks from a time when rooms were generously proportioned, and was in a good state of repair overall on acquisition, although the roof was showing its age, and the tiles would likely need replacing in the next few years. Fundamentally, the property is eminently capable of being lived in and let out.
Yasmin decides that she will convert the property into a six-room HMO. She consults a surveyor, and an architect with experience of the Local Authority’s requirements for HMOs, and the list of works includes:
Overall, the cost is significant, and would likely lead HMRC to enquire as to whether the expenditure should be disallowed. While Yasmin should expect to disallow some of these costs, it is likely that HMRC may prefer that disallowance be higher.
We shall assume that Yasmin has treated the cash basis for landlords with the contempt it deserves (for all but the most casual of landlords) and has and will continue to elect out of the regime each year.
Broad principles
Before diving into the specific components of the project, we shall consider the basic principles governing deductibility of repair costs, etc.
Capital vs revenue
Readers will likely be aware that expenses incurred ‘on revenue account’ are typically allowable, while capital expenditure is not (except that special provision in the tax code, such as capital allowances, may provide tax relief even so).
The dividing line between revenue and capital may well turn on the specific facts of a given case, and Strick v Regent Oil Co Ltd (1965) 43 TC 1 acknowledged that there was no single test that could be relied on in all cases, broadly.
Capital expenditure brings about an enduring benefit to the business – it is not consumed in the furtherance of the business (e.g., Atherton v British Insulated and Helsby Cables Ltd [1925] 10 TC 155)
Capital expenditure will likely be reflected in a change in the character of the asset, whereas revenue expenditure should act only to restore the asset to its original condition (e.g., Auckland Gas Co. Ltd v CIR [2000] 73 TC 266)
If on its acquisition an asset, even in a relatively poor state of repair, may nonetheless be used in the business, repairs will likely be revenue in nature. If, however, the asset could not be used in the business without significant repairs, that will likely be capital expenditure (contrasting the somewhat threadbare but still functional venues in Odeon Associated Theatres Ltd v Jones [1971] 48 TC 257 with a ship that was deemed unseaworthy and required special ‘permission’ to put out to sea, in Law Shipping Co Ltd v CIR [1923] 12 TC 621).
Does turning a single-household dwelling into an HMO change the character of the property?
While there will always be a question of ‘fact and degree’, this seems unlikely in most cases. While it is true that the total value of the entire project in this case study is substantial, being in the region of 15% of the cost of the property overall:
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it is doubtful that the value of the property will be expected substantively to increase as a result of the expenditure, much of which could be characterised as ‘making good’;
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all work has been undertaken within the existing envelope of the property and it would not appear to be inherently different in form or function to the casual observer; and
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actual structural work to the fabric of the property, such as moving internal walls, is quite limited.
In my opinion, this approach to converting a standard single-household dwelling into an HMO, as against a block of flats, broadly parallels what might be required to enable a typical family saloon car to be used as a private hire vehicle, as against a Hackney carriage. It is still somewhere for people to live; it has not been turned into a glue factory.
Single overarching project?
I am old enough to remember when the Inland Revenue (HMRC) used to try to argue that if works were sufficiently extensive to amount to a largely capital project, they should be treated as disallowable capital in their entirety – any repairs should be considered ‘incidental’ to the overall project. We can still see hints of this argument in HMRC’s Business Income Manual at BIM35460, and Paragraph 146 of the old IR150 booklet that covered extensive alterations to a property. But the case Conn v Robins Bros Ltd [1966] 43 TC2 66 (which is generally favoured by HMRC) supports the proposition that substantial projects may be apportioned, revenue element : capital element.
HMRC now states (in its Property Income Manual, at PIM2030):
‘Where a significant improvement arises from the change of materials, the whole of the cost is capital expenditure. This includes things like redecoration after the main work has been done.’
But also:
‘Work commissioned on a property may include expenditure on capital works and also separate expenditure on repairs at the same time. Here, the expenditure on repairs remains allowable. Expenditure may be apportioned on a reasonable basis to estimate the amount attributable to the repair element.’
So, if you redecorate the entire house, that would generally be on revenue account as a repair. But if you then moved an internal wall in a room, so you had to redecorate the entire room again as a result only of that capital improvement, then that repair cost might have to be subordinated to the essentially capital nature of the structural work. But nobody does things in that order; that would be ‘bonkers’. It seems more appropriate to consider that the cost of repainting the moved wall alone should be treated as capital, while the other walls are then repainted as part of the redecoration of the entire property – on revenue account.
Conclusion
Having set the scene of Yasmin’s project in broad brushstrokes, we shall return next month with an analysis of specific components of the schedule of works, with reasons – including why Balnakeil v HMRC [2021] UKFTT 0193 (TC) is so objectionable.
