Sarah Bradford explains how to determine whether expenditure on replacing a roof is revenue or capital, and why it matters.
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For tax purposes, all expenditure is not equal, and different rules apply to the treatment of capital expenditure and revenue expenditure.
Broadly, a landlord will be able to deduct revenue expenditure in calculating the taxable profits of their property business. By contrast, the treatment of capital expenditure is trickier. Depending on the nature of the expenditure and the type of letting and whether the accounts are prepared using the accruals basis or the cash basis, it may be possible to claim capital allowances, if the cash basis is used, to deduct the expenditure in accordance with the cash basis expenditure rules. Otherwise, relief will be given through the capital gains tax system as enhancement expenditure, reducing any gain on disposal.
While a homeowner may prefer capital gains tax treatment, a landlord may prefer to be able to deduct the costs in calculating profits; it is not possible to choose the preferred treatment. The boundary between capital expenditure and revenue expenditure is often a blurry one, and in deciding the extent to which relief is available for expenditure on replacing a roof, it is first necessary to understand when something is a repair and when something is an improvement.
What counts as a ‘repair’?
In its Property Income Manual (at PIM2020), HMRC defines a ‘repair’ as ‘the restoration of an asset by replacing subsidiary parts of the whole asset’. It illustrates this with the example of the cost of replacing tiles blown off by a storm.
However, in ascertaining whether works undertaken on a property would be classed as a repair, it is important to note that any works that result in a significant improvement of the property beyond its original condition would not qualify as a repair; instead, the expenditure would be regarded as improvement expenditure. This distinction is important – repairs generally constitute revenue expenditure, whereas improvements generally constitute capital expenditure.
It is also important to distinguish between a repair and a replacement – the former is revenue expenditure, and the latter is capital expenditure. The nature of the expenditure will determine how relief, if any, is given for the expenditure and when.
Identifying the asset
To determine whether something is being repaired or replaced, it is necessary to identify the asset on which the work has been undertaken – repairing an asset is a revenue expense, whereas replacing it in its entirety is a capital expense.
HMRC stress that there are no rules to be followed to give a definitive answer as to what constitutes the entirety of an asset; each case must be considered by reference to its own facts. However, there are general pointers that are useful in reaching a decision.
For example, when looking at buildings or structures, consideration should be given to whether the item that is being replaced is a free-standing asset. However, the fact that it may be connected to another structure does not necessarily make it part of that structure; although a fixture other than an integral fixture (such as a boiler), which is treated as a separate asset, is treated as part of the building rather than as a separate entity. Thus, the ‘asset’ would be the building as a whole, rather than the roof.
A fixture is something that is intended to be attached to a building permanently so as to make a lasting improvement to it. As a result, replacing a fixture on a like-for-like basis would be a repair rather than capital expenditure, which suggests at first sight that replacing a roof will be a repair. Indeed, while in its Property Income Manual, HMRC talks about repairs to a roof in terms of replacing roof tiles, flashing and gutters, rather than a replacement of an entire roof, in its Business Income Manual at BIM46915, it provides an example to illustrate the difference between a repair and an alteration in which the roof is replaced and the building modernised and extended. In relation to the roof replacement, it states:
“The new roof simply returns the roof to its original condition. It is neither an alteration nor an improvement. It is simply a repair of the building.”
Replacing part of an asset in itself is not sufficient to guarantee a revenue deduction for the costs – the replacement must be on a like-for-like basis; improving the asset rather than replacing it turns it from a repair cost into capital expenditure.
‘Significant’ improvement?
While the nature of a repair is that it restores the asset to its original condition, if the work undertaken in doing so results in a significant improvement to the asset, the expenditure will be regarded as capital rather than revenue. The key question here is: what constitutes a ‘significant improvement’?
In its Property Income Manual at PIM2030, in response to the issue of when there is a capital improvement, HMRC states:
“It is largely a question of fact and degree in each case whether expenditure on a property leads to an improvement.”
It also notes that where the degree of improvement is so small as to be incidental to the repair, in the absence of any other indicators to suggest that the expenditure is capital, the full amount would be regarded as revenue expenditure, and deductible in computing the profit of a property rental business.
It is also important to note that where the improvement relates simply from the use of new materials, as long as they are broadly equivalent to the old materials, the expenditure will remain revenue expenditure. Here, the example given is the replacement of wooden beams with steel girders.
A roof may be replaced simply because the old roof has fallen into disrepair, or the replacement of the roof may be part of a larger project involving the renovation of a derelict property. Here, it is worth noting that HMRC cites “the cost of refurbishing or repairing a property bought in a derelict or run-down state” as an example of capital expenditure (see PIM2030).
Where the alterations to a building are so extensive to amount to the reconstruction of the property, the expenditure will be capital rather than revenue. Rebuilding costs cannot be deducted in calculating the profits of a property rental business but would be taken into account in calculating any gain on disposal of the property. However, if part of the old building is preserved and the roof on that part is replaced, this would count as a repair.
Derelict property
It will not always be clear whether work undertaken on a derelict building is capital or revenue and HMRC’s guidance fails to provide definitive answers. While it states that “the cost of refurbishing or repairing a property bought in a derelict or run-down state” would be capital expenditure, later in the same paragraph, HMRC further states that “repairs to reinstate a worn or dilapidated asset are usually deductible as revenue expenditure” (the key here being that the expenditure ‘reinstates’ the asset in its former state).
Where a property is purchased in a derelict state, the fact that work is undertaken shortly after the property was acquired does not in itself make the expenditure capital expenditure. However, if the property was acquired in a state that was not fit for use in the business until the work had been undertaken, or it would not be possible to continue to let the property unless work is carried out, the expenditure may be treated as capital. Similarly, if the price of the property was substantially reduced because of its dilapidated state, the expenditure may be capital.
However, if the purchase price merely reflects normal wear and tear, work to remedy this would remain a repair. It may also be possible to argue that work undertaken to a derelict or run-down property in order to sell it and secure a higher sale price is capital rather than revenue.
Conclusions
There is no ‘yes’ or ‘no’ answer to the question of whether expenditure on the replacement of a roof is capital or revenue expenditure, as it will depend on the circumstances and the extent of the work undertaken.
While the pendulum will generally swing in favour of the expenditure being a revenue repair, replacing a roof, as part of a significant renovation project or to ensure that a newly purchased property is in a fit state to be let out, will be treated as capital expenditure.
Practical tip
Consider the facts when assessing whether the replacement of the roof is a repair or an improvement and keep documentary evidence to support your conclusions.
