We are frequently asked to comment on whether or not landlords are entitled to claim tax relief on the costs of repairs or renovations to a newly-acquired property, where such costs are incurred before the property is first let.
It is right to acknowledge that HMRC often scrutinises such expenses, in the hope of disallowing at least some of the expenses incurred on the basis that they are capital improvements to the property. But note that, even if costs are disallowed against rental income because they are capital improvements, they may then be carried forward indefinitely to set against proceeds on eventual disposal of the property – a capital gains tax event. Those costs allowed against capital gains may not get tax relief immediately, nor at the 40% or 45% ‘premium’ rates of income tax. But they will still save tax at up to 28%, so are not to be ignored completely.
There are, in fact, very few expenses that cannot be claimed either as a deduction against income from a rental business, or as a capital cost of improving the asset, offset when the asset is sold. The only significant categories would be:
- private expenses that weren’t really to do with the business in the first place (a simple example would be the cost of maintaining a property while occupied by the owner as a private residence); and
- capital expenditure on an improvement that is no longer present when the asset is sold, such as if a new conservatory is added to a property (that didn’t have a conservatory before – hence a capital improvement), but is pulled down a few years later, when (say) the owner decides it is too expensive to heat and takes up too much of the rear garden. Once demolished, the cost of the conservatory could not be claimed against the later sale of the house.
Examples: expenditure on additional properties
Example 1: Mr Jeeves
Mr Jeeves, who is an established property investor, adds another property to his portfolio. The property was sold as a private residence by its previous owner/occupier, so it was clearly habitable, and was bought and sold on the basis that it was ‘liveable in’. Mr. Jeeves incurs £10,000 on the following:
- new bathroom;
- new kitchen;
- replacing all carpets; and
- re-decorating throughout.
This approach would be common amongst many landlords, who want to try to make sure that their first letting period is reasonably trouble-free, and to get the work done while not inconveniencing a tenant. Mr Jeeves estimates that it may take up to two years of letting before the property has paid off this up-front cost. But he expects to be able to claim tax relief on that expense, effectively netting the immediate loss on this new property against the aggregate incomes from the rest of his portfolio.
It is entirely possible that HMRC might want to scrutinise these expenses. It is not essential that the property be sold by an owner-occupier (or be otherwise lived in immediately prior to Mr Jeeves’ purchase). The point is that, if the property were un-inhabitable, because it had no kitchen, no bathroom and no carpets, then it is arguable that the expenditure was necessary to make the property habitable (and therefore lettable) and was therefore a capital improvement.
It might also be easy for HMRC to argue that the work improved the property – otherwise, why was it incurred? But has the expenditure materially enhanced the capital value of the property? It would seem unlikely, since the work was basically cosmetic, and no more than any property owner has to undertake, from time to time, when maintaining an asset.
Mr. Jeeves will aim to demonstrate that the quality of the kitchen fittings, bathroom, etc., was not substantively superior to the quality of those that they replaced when they (the former) were newly installed.
Example 2: Mr Rooster
Mr Rooster is also a seasoned landlord. He acquires a property with a problem tenant, whom the current owners have struggled to remove from the property for some time, but to no avail. The property is in a poor state of repair and would need updating anyway, to appeal to the type of tenant whom Mr. Rooster would like to attract.
Sold in the same physical state but with vacant possession, the property would be worth £220,000 but Mr Rooster estimates that legal fees alone will cost up to £25,000 – and (at least) several months of lost rents – to remove the current occupier and so he negotiates the price down to £175,000 accordingly.
Clearly, the market value of the property has been significantly affected and, while he may be pleased that he has negotiated a substantial discount, Mr Rooster may be disappointed when his adviser warns him that whatever costs he does incur to extract the current tenant will, in these circumstances, be considered a capital cost. The money and effort that Mr Rooster will put in will result in a significant improvement to the property’s value, and this is really no different to buying a property whose value has been significantly ‘blighted’ by damp, knotweed, or similar.
Points to note
The effect on value is substantial in the latter example. Where the value of a property is adjusted only a little in relation to what one might ordinarily consider to be its ‘normal’ market value, to reflect the ‘everyday’ costs of looking after such an asset, work to maintain or repair the property would not necessarily be considered capital at all, but simply the ongoing cost of maintaining an asset – allowable against the income of a property business.
This would be the case even when the work/cost is incurred immediately after the property is acquired. It would be a nonsense to defer replacing the missing wing mirror of a second-hand car until after you’d driven it for a few months; it might be a different matter if the engine were missing – and the price of the car would surely be different in either scenario.
However, if Mr Rooster had acquired the property in ‘normal condition’, and then some time later found that substantial costs had to be incurred to maintain its value, they would be deductible from his property investment business profits. This would be like buying a second-hand car and happily driving it for a few months before the engine blew up; it would be a very expensive undertaking to replace the engine but it would nonetheless do nothing more than recover the value that the car had when you first bought it.
Practical Tip:
Properties can be expensive, and the cost of maintaining them can be substantial enough to trigger scrutiny from HMRC. There are levels of complexity and numerous cases about the ‘capital v revenue divide’, but a simple rule of thumb is, does the expenditure tangibly increase the value of the asset, or does it just protect/maintain the value it already has?
