Lee Sharpe looks at how landlords could claim for the cost of renovating a property before first let.
This article looks at the tax treatment of pre-letting expenditure and how this can change, depending on the circumstances. Landlords will typically prefer that expenditure be categorised as revenue repairs rather than capital improvements because:
- it will get tax relief sooner against their rental income stream; and
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it will typically get tax relief at higher rates: income tax is payable at 20%, 40% or even 45%, while CGT is 18% or 28% for residential property gains (or 10% or 20% for gains other than on residential property).
Capital vs revenue
Most importantly, expenditure is not forbidden relief against rental income simply because it is incurred before the property is let out. Landlords often find it practically convenient to undertake a substantial programme of renovations before a property is first let; this can often run to many thousands of pounds, and even an initial rental loss. These factors do not prevent relief for income tax purposes. The fundamental question is to what extent (if any) some or all the work done results in a substantive enhancement to the value of the property. So, for example:
- the cost of adding a conservatory or extending into the roof space to add an extra bedroom would be capital and potentially deductible in the long term against capital gains if the improvement is still reflected in the asset on later disposal; and
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replacing carpets, bathroom and kitchen in a property with items of a similar quality (to the replaced items when they were newly fitted) will likely be allowable against rental income.
It is important to be able to show that the property was capable of being let out commercially before substantive renovations were undertaken to prove that the property was suitable for being used in the business without substantive (and implicitly capital) costs being necessarily incurred.
This may be quite straightforward if (say) the property was sold by another landlord. However, if the particulars of sale suggest that it needs significant work prior to further occupation, or has been heavily discounted to reflect dilapidations, it is likely that at least some of the work will necessarily be capital in nature (but see Apportionment below).
Timing of expenditure
Where the expenses have been incurred before a rental business has even begun, then so long as they would have been allowable for an ongoing property business and were incurred no more than seven years before the property business did commence, they are claimable on the first day of commencement.
This gives landlords plenty of time to undertake repairs to their first properties.
Only one letting business
Most landlords will have only one property letting business, whether they have one or fifty properties (but if they let properties in different capacities, such as in a separate partnership or as trustees, those will be pooled separately).
It follows that after the initial phase of pre-letting expenditure on their very first property, repair costs on subsequent properties will generally be allowed as part of ongoing property business costs. This does not just mean that all pre-letting expenditure after the first property must be allowed against rental costs; the capital or revenue question is essentially the same each time a new property is taken on and renovated, etc. Rather, it points to the timing of when the deduction is allowed – if the landlord incurs (say) £3,500 of deductible renovations cost on acquiring their third rental property, they do not have to wait until that property is let to claim the relief.
Apportionment of expenditure
Where there is a mix of capital improvements and revenue repairs, the repair element may be claimed.
HMRC has been known to argue in the past that a ‘scheme of works’ that has capital improvement elements should be treated as wholly capital and all disallowed (pending capital gains tax (CGT) on disposal, etc.) This is incorrect, and even the Property Income manual (at PIM2030) accepts that repairs undertaken alongside capital improvements ‘may be apportioned on a reasonable basis’ to allow the repair costs.
Cash basis
Readers should be aware that individual landlords subject to income tax are subject to the cash basis regime by default, broadly so long as their rental receipts in a tax year are less than £150,000.
In theory, a regime that concentrates only on amounts received and laid out should not distinguish between ordinary income or capital receipts; the landlord should get relief immediately, either way. However, that ideal is heavily modified by the cash basis legislation, which restricts the scope of the regime, leaving land, property and improvements firmly in the CGT camp (see, for example, HMRC’s Property Income manual at PIM1095).
The government wants to make it quite difficult for landlords to escape the clutches of the cash basis; one must elect out of the regime each and every year. HMRC is keen to highlight the supposed simplicity of the regime (in reality, it is anything but simple) and it is purely coincidental that it was originally forecast to generate tax revenue for the government when it originally consulted on the proposal in August 2016! This writer believes that most ‘serious’ landlords with substantial property income should, in fact, elect out of the cash basis each year.
In terms of capital gains and improvements, however, the government’s decision to ring-fence property gains is arguably a blessing in disguise, given that a ‘true’ cash basis would instead have made capital gains on property disposals taxable at the full rates of income tax – anywhere up to 45%, etc.
Interesting times
At the time of writing, it appears that the chancellor has resisted growing political pressure to equalise CGT rates alongside income tax rates, at least for disposals of residential property – so that capital gains would then be taxed at 20% where falling in the basic rate, and 40% where they fall in the individual’s higher-rate bracket.
To this writer, the Chancellor’s reticence is entirely understandable given that, having abolished indexation allowance many years ago, the government has effectively removed any means of stripping away the capital gain attributable purely to inflation – particularly when inflation is running at circa 10% a year, as currently. It would be grossly unfair to apply tax at 40% to an asset where a good proportion of the taxable gain has arisen only on paper, by reference to rising costs generally over several years.
It could be argued that the introduction of the special regime restricting income tax relief for residential property finance costs that was implemented progressively from April 2017 suggests that fairness, logic and the taxation of landlords do not always mix well. If any such alignment were to take place, it might easily serve only to increase the appeal of running the property business through a corporate wrapper, assuming that disposing of the shares in the company, rather than the property directly, would mean the individual having to pay CGT rates (as now) of only 10% at the basic rate, or 20% at the higher rate.
Conclusion
Landlords should not assume that renovation expenses incurred prior to their first let of a new property must be treated as disallowable in their property business by default and saved only for CGT. Where the work done to the property does not give rise to a substantive enhancement to the property’s capital value, it may well be deductible for income tax purposes. Typically, it will help if the property valuation includes a projection of the rental income, and photographs are taken to evidence the quality of the accommodation prior to any substantial renovation works.
However, even if the expenses are not allowable immediately and may be claimed only under CGT against a future disposal, those costs should be jealously guarded; they will currently save tax at up to 28% for residential property and may well be worth even more if CGT rates do, in fact, increase at some stage.
