Sarah Bradford looks at whether any reliefs are available for the costs of undertaking alterations to property.
Taking on a property renovation project has an appeal for many people. Buying a property in need of work is cheaper than buying one where everything has been done; and starting with what is effectively a blank slate allows you to put your own stamp on the property.
However, the costs involved in renovating or altering a property are likely to be significant. The extent to which any tax relief is available will depend on how the property is used and on the nature of the expenditure.
Capital v revenue
When any work is undertaken on a property, it is necessary to identify whether the costs are capital or revenue in nature. In any extension or alteration work, there are likely to be costs that fall into each camp.
The costs of refurbishing or repairing a property which was purchased in a derelict or run-down state are capital expenditure. An example would be a renovation of a house which had not been touched for many years. Likewise, expenditure which adds or improves the land or property is capital expenditure. Examples where this might be the case would include converting a large house into flats, a barn conversion or an extension.
Where the alterations to a property are so extensive as to amount to the reconstruction of the property, the expenditure will be capital expenditure. Rebuilding, regardless of whether this is from choice or necessity, is capital expenditure.
Although when undertaking extensive alterations to a property, it is likely that significant capital expenditure will be incurred, this does not mean that all expenditure associated with the project will be capital expenditure. Any repairs will remain revenue in nature even when undertaken at the same time as major capital works.
For example, if a property is extended and, during the work, the roof of the original building is repaired, the repair to the roof remains a revenue expense, irrespective of the fact that it was undertaken as part of a larger project extending the property. Likewise, if a building is substantially rebuilt but part of the original building is retained and repaired, the repairs costs remain revenue expenditure.
Splitting costs between capital and revenue
Where work undertaken on a property includes both capital works and repairs, the expenditure should be split in a just and reasonable fashion so that the amount of the capital expenditure (and what it relates to) and the amount of the revenue expenditure can be clearly identified.
The split should be backed up by supporting documents, such as receipts, builders’ invoices and quotes. To resist potential challenges from HMRC that an item treated as a revenue expense is really capital expenditure, it is important that good records are kept.
Home or let property
The availability of relief for revenue expenditure depends on whether there is a business. If the property is used solely as a home, no tax relief is available for any revenue expenses incurred as part of the alteration works.
However, if the property is let to tenants or used as a holiday let, relief for revenue expenses may be available.
Relief for revenue expenses
Where there is a property income business or a furnished holiday lettings business, relief is available for revenue expenditure to the extent that the costs are incurred ‘wholly and exclusively’ for the purposes of the business. The costs are deducted in computing the taxable profits of the property income business or the furnished holiday lettings business, as appropriate.
Where the taxable profits are computed under the cash basis (which is the default basis for landlords whose gross rental receipts do not exceed £150,000), expenses are deducted in the period in which they are paid. If the accounts are prepared under the accruals basis (either through choice or because the landlord is not eligible for the cash basis), relief is given for the period in which the expenses are incurred.
Where the revenue expenditure is incurred during works undertaken in getting the property ready to let, relief may be available under the normal rules if the landlord has other properties in their property rental business or furnished holiday lettings business, or the pre-letting expenditure rules where the property is the first property in the business.
Where a landlord has more than one property in a property rental business, profits for the business are found by taking into account all income for all properties in the business, less all expenses incurred in relation to those properties. Thus, if a landlord with an existing property rental business buys a new property to rent out and incurs revenue expenditure in getting the property ready to let, the revenue expenses are deductible when working out the profits for the property rental business as a whole. Similar rules apply if a landlord has existing furnished holiday lets and incurs revenue expenditure in relation to a new property prior to it being let as a holiday let.
Where there is no existing business and the property is purchased with the intention to rent it out or to use it as a holiday let, any revenue expenses incurred in getting the property ready to let are relievable under the pre-letting rules. This treats the expenses as if they were incurred on the day that the business started, as long as they have been incurred in the previous seven years and relate wholly and exclusively to the business.
Capital expenditure
Relief for capital expenditure is, in the main, given under the capital gains tax (CGT) rules when the property is sold. Any improvement expenditure is added to the purchase cost of the property and other allowable costs, such as the incidental cost of purchase and sale, stamp duty land tax and suchlike when working out any chargeable gain or allowable loss on sale.
Where a property has been the only or main residence throughout, there is no CGT to pay. However, if the property has not always been a main residence, any capital expenditure on improvements is taken into account when working out the gain not sheltered by main residence relief.
In a business context, relief may be available for capital expenditure, either under the cash basis rules or the capital allowances system, although in reality this is limited. No deduction is available for property improvement costs under the cash basis rules. Plant and machinery capital allowances are available for furniture and furnishings in a furnished holiday lettings business. In a residential let, there is no relief for the initial cost of furniture and fittings; instead, relief is deferred until the item is replaced and the landlord can deduct the cost of a like-for-like replacement in computing profits.
Consequently, where extensive alterations are undertaken to a property which is either let as a residential let or used as a furnished holiday let, relief for the capital expenditure will normally be given in computing the chargeable gain or allowable loss on the eventual sale.
Example: Renovation of farmhouse and barns
Martin purchases a run-down farmhouse with three barns. He plans to use the farmhouse as his family home and convert the barns into residential accommodation.
He spends £400,000 extending and renovating the farmhouse, plus £35,000 on repairs to the existing building. He also spends £200,000 converting Crab barn, £175,000 converting Lobster barn and £150,000 converting Oyster barn. In addition, he incurs revenue expenditure on repairs to the existing barns of £12,000, £18,000 and £10,000 respectively. When the work is complete, the barns are let.
No relief is available for the repairs to the farmhouse.
The property income business commences on the date that the first barn is let. The money spent on repairing all three barns (£40,000) is treated as incurred on that date and deducted in computing the profits for the first tax year.
Some years later, he sells Crab barn for £500,000. The improvement expenditure of £200,000 is deducted in working out the capital gain on the sale.
Practical tip
When undertaking extensive alteration to a property forming part of a property rental business or furnished holiday rental business, keep a record of all expenses and make sure that you can identify what are revenue expenses and what are capital expenses. Remember to claim relief for revenue expenses against profits.
