Lee Sharpe looks at some of the tax implications of converting a large property into a house in multiple occupation.
In the previous case study in this series of articles, I looked at what happens when extensive repairs are required following a long period of letting. In this case study, I will look at what happens when a landlord decides to convert a standard single-family dwelling into a house in multiple occupation (HMO).
Case study 5: HMO project
Sean has a large Edwardian townhouse that he has let for some years as a single dwelling to a tenant who has just vacated the property. He decides to convert the property into an HMO capable of being occupied by five separate tenants. The property will require some extensive remodelling, and he gets his usual builder to quote for the following works, which will take approximately 20 weeks to complete:
Clearly, the cost of the work is substantial, but Sean calculates that his annual income from the property will rise from a little over £20,000 a year to well over £30,000 a year, and will effectively return the outlay within four or five years.
VAT: Single or multiple dwelling – And why does it matter?
HMOs typically sit on or around the notional boundary-line between single dwellings and separate apartments, given that there is separate accommodation for unrelated tenant families or households, but there are common living, kitchen and bathroom areas. Sean’s project to convert the property from a single dwelling into an HMO will likely attract special VAT treatment – and Sean potentially stands to benefit, even though his residential landlord business is not VAT-registered.
This is because HMRC generally accepts that converting a single-household dwelling into an HMO means a builder need charge Sean only 5% VAT rather than 20% VAT. As builders can still recover their own VAT costs as normal, this should mean a reduction in project cost of around 12.5%, where the 5% rate can be applied. Note that the 5% rate will also usually apply to materials supplied by the builder as part of his construction services to Sean, so Sean will probably prefer for the builder to source materials, etc.
Beware mandatory improvements
As many readers will be aware, the standards expected of large HMO properties can vary in the practical implementation from one local authority to the next. Some local authorities will insist on more stringent safety measures than others before agreeing to issue a licence. Let’s assume that in this case, the local authority will license the property only if:
- a high-standard fire alarm and safety system is installed – to a higher specification than one would expect in a normal private domestic residence; and
-
some of the wiring etc. must be improved and requires a higher-specification mains consumer unit to replace the existing ‘normal’ unit in the entrance hall to the property.
Sean might assume that if he must use higher-quality installations in the transition to achieving HMO licensing, then the costs must surely be tax allowable. But he would be wrong, because HMRC will argue that it is a capital (long-term) improvement to the building and not merely keeping pace with modern technology or electrical engineering standards etc.
Capital allowances
However, to the extent that wiring, fire, and video security systems are not inside dwelling areas, then even as capital improvements, they may get relief through capital allowances – and potentially the 100% annual investment allowance (AIA).
Capital allowances within a normal let, residential dwelling are prohibited, but HMOs, like apartment blocks, have areas that are common but do not ‘belong’ to any dwelling(s) (typically entrance vestibule, hallway, common stairwell, basement, roof void, etc., separate from living or communal areas).
Tax claims
Sean is able to get a lower project/construction cost and claim some of the expenses against his rental income, as follows:
Firstly, Sean’s costs have been reduced across the board, because his builder is able to charge only 5% VAT on the project (it is possible, for large projects, that HMRC could argue that some of the work does not relate specifically to changing the number of dwellings, so it should be at the standard 20% rate, but the likely impact on a project like this is small and has been ignored for simplicity).
Secondly, Sean can claim a proportion of the re-wiring work that comprises simple repairs to the existing wiring, i.e., it is neither additional wiring (new sockets, etc.) nor a substantively superior replacement.
He is also eligible to claim for the proportion of decorating, etc., that is not required by the structural or improvement work. So extending the kitchen warrants re-decorating the kitchen, but many rooms may well have been untouched by the structural work and just need re-decorating anyway.
Out of the capital improvements of £49,250, Sean is then able to claim capital allowances (presumably 100% AIA) on the new consumer unit, which is not located in a dwelling or communal area, on the fire safety systems to the extent that they are not in dwelling areas, and likewise on the new video security system.
Sean has therefore managed to reduce his ‘hidden’ VAT costs by almost £10,000 and will get immediate tax relief on more than £10,000 out of the remaining expenditure.
Practical tips
Landlords often ignore VAT because they take it as a built-in cost, but on serious construction projects, they may be pleasantly surprised to find VAT costs should be reduced – potentially even to 0% for brand new dwellings – so the real cost to them should fall. However, there are often procedures to follow (e.g. ‘certifying’ a project) and, while some builders may already know a project should get a lower VAT rate, it is typically the landlord or landlady (as client) who has to drive the process.
Generally, converting a loft space will ‘count’ as re-working an existing building, and HMRC certainly does not like the idea that it could count as a brand-new 0% VAT dwelling; but see Jahansouz v HMRC [2010] UKFTT 355, in HMRCs VAT Construction manual at VCONST02200.
Also, given that the current ‘annual’ VAT registration threshold is £85,000, beware builders quoting for expensive projects but who are not VAT-registered, as they may suddenly become more expensive if they start having to charge VAT halfway through a project.
There are some people who interpret the case Tevfik v HMRC [2019] UKFTT 600 (TC) to mean that capital allowances are no longer available to the ‘common parts’ of the building. That is probably because they have not read the case properly! However, there is a distinction between eligible ‘common parts’ as above and communal living areas such as kitchens, living rooms and similar.
Finally, note that there is a risk, as property investor construction projects get larger, that HMRC will argue that the investor has suddenly transmogrified into a property developer for the purposes of the construction industry scheme (CIS), and will have to start making CIS returns (and potentially payments) to HMRC, at least for the duration of the project.
Finally, always take advice before a substantial project starts!
