As demand for rental properties remains strong, property investors will look at ways to adapt existing property for better rental returns. Typically, this will involve houses in multiple occupation (HMOs), or converting larger properties into more permanent apartment-type accommodation.
Key points
- HMRC is likely to want to consider whether or not pre-letting expenditure should be allowed against the rental income, or disallowed as capital expenditure.
- Structural alterations are likely to be capital expenditure.
- Just because an expense is necessarily incurred for a business venture, even if it is a legal requirement, does not automatically mean it must be allowed against rental profits.
- A scheme of works that involves both capital and revenue expenditure can be apportioned so that the revenue expenditure may be deducted from rental income, even though the capital portion must be disallowed.
Capital or revenue?
Expenditure incurred to maintain a property is allowable against rental income, while the cost of improving it is capital and cannot be claimed against rental income. But capital expenditure will be claimable when the property is sold or otherwise disposed of, as enhancement expenditure, so long as the improvement is still part of the property then being sold/disposed of (this will almost certainly be the case with property, unless something has been demolished).
A bit of both?
HMRC aims to disallow costs or projects that are capital in nature. However, it is possible still to claim a proportion of the project costs which are identifiable and attributable to maintenance or similar work. The historic case for this is Conn v Robins Bros Ltd [1966] 43 TC 266. You might think that is now settled, 50 years on. Certainly, HMRC’s own guidance confirms that such costs may be apportioned in its own Property Income manual at PIM2020.
Unfortunately, it seems HMRC still does not really ‘get it’, as the more recent cases G Pratt & Sons v HMRC Commissioners [2011] UKFTT 416 (TC), and Hopegar Properties Limited v Revenue and Customs [2013] UKFTT 331 (TC) demonstrate.
Example 1: Conversion into HMO
Caroline acquires a large three-storey Victorian house and sets about converting it into an HMO, with shared kitchen and bathroom facilities. Each bedroom will have its own washing facilities, two bathrooms will be replaced (to a similar standard as when the existing fittings were newly installed) and one more added. The two largest bedrooms on each of the two top floors will be partitioned into two separate bedrooms. The kitchen downstairs will be completely replaced, and again to a similar standard as existing; however, additional cupboard space and fixtures will be required.
As part of the overhaul, the property will be re-wired, re-plastered, and decorated throughout. However, the local licensing authority for HMOs insists on the fire safety provision being to a tangibly higher standard than for an ordinary dwelling, or an HMO licence will not be granted.
Work Cost (£) Revenue (£) Capital (£)
Partitioning the largest bedroom
on each of the first and second
floors to get two extra bedrooms 5,000 - 5,000
Upgrading fire safety system
throughout the building, over and
above residential use, required
in order to secure HMO licence 4,000 - 4,000
Rewiring the property, which
includes the addition of several
new power and lighting points 6,000 5,000 1,000
Washing facilities in each room
(but replacing in two bedrooms,
which already had ensuite facilities) 2,500 1,000 1,500
Extra bathroom 4,000 - 4,000
Re-fitting the kitchen and adding
extra cupboard space, cooking
and refrigeration facilities 6,000 4,500 1,500
Structural repairs 2,500 2,500 -
Redecorating/plastering
throughout 8,000 7,000 1,000
TOTALS 38,000 20,000 18,000
Clearly, substantive structural alterations are going to be capital in nature. However, a careful review of the work done reveals that more than half of the cost may reasonably be claimed against rental income. Replacing fixtures to a similar standard is not an improvement but a repair to the property. It is only where Caroline has added to the fixtures (such as in the kitchen, or with additional plugs in the re-wire) that the additional work will rank as a capital improvement.
Just as with the re-wire and the kitchen, there will be rooms that were re-decorated after improvements (such as with the new bedrooms and bathroom), and there will be rooms which were simply re-decorated, and on that basis an apportionment should be possible.
It may surprise some readers, but the requirement to improve the fire safety provision will not be an allowable expense just because the business wouldn’t have existed without it. It will be a capital improvement to the building.
Example 2: Conversion into flats
Jose has acquired a similar property to Caroline, but prefers instead to convert his three-storey property into three separate self-contained apartments. To cut costs, he will retain the original kitchen and bathrooms (although he will replace the fittings). He installs a lift for access to the higher storeys.
Work Cost (£) Revenue (£) Capital (£)
Structural alterations 25,000 - 25,000
Re-wiring – including separate
meters 15,000 5,000 10,000
Replacement (to a similar standard)
and additional kitchens and
bathrooms 20,000 8,000 12,000
Redecorating/plastering
throughout 8,000 4,000 4,000
Lift installation 25,000 - 25,000
TOTALS 93,000 17,000 76,000
It will come as no surprise that Jose’s opportunities for revenue treatment are thinner on the ground, given the emphasis on structural works in the second example. Nevertheless, replacing the original kitchen and bathrooms will count as repairs, as will some of the re-decorating, plastering and wiring work.
Perhaps Jose’s position can be improved by pointing out that:
- converting an existing dwelling into more (or even fewer) dwellings attracts the reduced rate of VAT on construction services. This means that, where Jose’s builders are charging VAT for their work (and the goods that they supply as part of those works), then Jose may be charged at only the reduced rate of 5%. Jose will not normally be VAT-registered himself, so a reduction in VAT will represent a potentially quite significant saving (Jose cannot get the VAT reduction directly; it must be through works charged by VAT-registered builders, etc.); and
- the cost of the lift and structural alterations to incorporate it into the building may be eligible for capital allowances, assuming the lift is outside the living space part of each apartment it services. As the first £200,000 of eligible expenditure in any year is in turn eligible for the annual investment allowance, Jose’s £25,000 capital expenditure on the lift could get immediate 100% tax relief.
Practical Tip:
Generally speaking, conversions of pre-existing dwellings will involve capital expenditure, but there will often also be opportunities for tax savings, if you know where to look. It is therefore important also to keep track of the improvement costs that were disallowed against rental income, so that they can be claimed when the property is sold, assuming the improvements are still there.
