Sarah Bradford explains the difference between revenue expenditure and capital expenditure and how the tax system provides relief for different types of expenditure.
As far as the tax system is concerned, not all types of expenditure are equal; a distinction is drawn between revenue expenditure and capital expenditure. This distinction is important as it determines the extent to which and the way relief for the expenditure, if any, is given.
For capital expenditure, it is also necessary to take into consideration how the accounts are prepared, as different relief mechanisms apply to the ‘cash basis’ and the ‘accruals basis’.
No simple test
One of the difficulties in determining whether a particular item of expenditure is revenue rather than capital expenditure is that there is no single, simple test which can be used to decide which camp the expenditure falls into. Rather, the classification will depend on the particular circumstances and nature of the business; the same item may be correctly regarded as capital expenditure in one business, and as revenue expenditure in another. The categorisation is context dependent.
A further example of expenditure that may be capital or revenue is that of legal expenses, which follow the nature of the expenditure to which they relate. So, legal costs relating to the purchase of an investment property would be capital in nature, whereas legal costs incurred to recover unpaid rent would be revenue in nature.
Where revenue and capital expenditure are undertaken at the same time (e.g., if repairs are carried out at the same time as undertaking improvement works), the different elements of the expenditure are treated accordingly.
Revenue expenditure
Broadly, revenue expenditure is incurred in the day-to-day running of the business. In a property business, the landlord may typically incur the following items of revenue expenditure:
- Accountancy fees.
- Advertising for tenants.
- Cleaning.
- Office expenses.
- Staff costs.
- Interest and finance costs.
- Gardening.
- Travel costs.
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Repairs and maintenance.
Care should be taken in determining whether work undertaken on property is maintenance or a repair, or is an improvement. The distinction is important; while repairs and maintenance costs count as revenue expenditure, any money spent on improving or enhancing the property will be capital expenditure.
Broadly, a repair will be something that reinstates it to its original condition (allowing for improvements in materials and technology over time), whereas something that substantially improves the property is likely to be an enhancement. In the absence of capital indicators, HMRC will usually accept that the cost of replacing wooden beams with steel girders or replacing lead pipes with copper pipes is revenue expenditure.
Costs incurred in keeping the property in a good state of repair (e.g., repointing brickwork, replacing loose roof tiles and suchlike) will usually be revenue in nature. Likewise, where an improvement arises simply as a result of advancements in technology, but the function and character of the asset is broadly the same, the expenditure will normally be allowable as revenue expenditure. An example of this is the replacement of single glazed windows with double glazed windows.
Relief for revenue expenditure
The general rule is that expenses can be deducted if they are incurred wholly and exclusively for the purposes of the business. The treatment of revenue expenditure is the same regardless of whether the accounts are prepared under the ‘cash basis’ or under the ‘accruals basis’.
The ‘wholly and exclusively’ requirement precludes a deduction for private expenditure. However, where an expense is incurred for both private and business purposes, a deduction is allowed for the business element, if this can be identified separately.
For example, if a landlord uses his phone for business and private calls, the cost of the business calls can be deducted as a revenue expense when computing the profits of the property rental business (assuming that this can be determined, for example, from call logs). However, if the business and private use cannot be separated, a deduction is not permitted as the ‘wholly and exclusively’ test is not met.
Special rules apply to interest and finance costs where these are incurred by an unincorporated property business in relation to a residential let. The costs are given as a tax reduction equal to 20% of the finance costs. However, property companies and landlords of furnished holiday lettings are not subject to this restriction and can deduct the costs fully in computing their profits.
It should be noted that a deduction is specifically prohibited for entertaining costs, even where these are incurred ‘wholly and exclusively’ for the purposes of the business.
Capital expenditure
Capital expenditure is, broadly, expenditure on items that are retained in the business and which are used to generate the profits. In a property income context, this will include the cost of the land and the property itself, the cost of any new building erected after the letting has started, and any enhancement or improvement expenditure. As noted above, legal costs incurred in relation to capital expenditure (e.g., the purchase of the property) are also capital in nature.
Other examples of expenditure that may be incurred by a property business which are capital in nature include:
- Expenditure which adds to or improves the land or property (e.g., converting a barn into a holiday home).
- The cost of refurbishing or repairing a property brought in a derelict or run-down state.
- The cost of furnishings for a property that is let furnished.
- Equipment, such as domestic appliances, which are purchased for a let property.
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Vehicles, such as cars or vans.
As a guide, capital expenditure adds something to the property that was not there before, or upgrades an existing feature. It will often add value.
Relief for capital expenditure
The rules governing the relief for capital expenditure depend on whether the accounts are prepared under the ‘accruals basis’ or under the ‘cash basis’.
(a) Accruals basis
Under the accruals basis, capital expenditure cannot be deducted in calculating the profits of the property business. The extent to which relief is available depends on the nature of the expenditure.
For example, depending on the type of property business, relief may be available under the capital allowances system. Where the let is a commercial let or a furnished holiday letting, plant and machinery capital allowances (i.e., the annual investment allowance or writing down allowances) can be claimed for qualifying expenditure. Capital allowances may also be available for integral features, such as a hot water system or a lift in a block of flats, and for vehicles such as cars or vans.
Landlords letting residential property are not able to claim capital allowances; however, a separate relief applies to replacement domestic items. This relief allows the cost of a like-for-like replacement to be deducted in computing profits, although no relief is given for the initial cost.
Relief for the cost of the actual property itself, plus any enhancement expenditure, such as the cost of an extension, is given through the capital gains tax system when the property is sold. The cost of the property, plus any enhancement expenditure and the associated costs of acquisition and sale (legal fees, estate agent’s fees, stamp duty land tax, etc.) are deducted when computing the gain or loss on disposal.
(b) Cash basis
The cash basis is the default basis of accounts preparation for unincorporated property businesses with annual rental income of £150,000 or less. The cash basis has its own capital expenditure rules.
Under the cash basis, capital expenditure is simply deducted when computing profits unless it is of a type for which this treatment is specifically excluded. The main exclusions are land and buildings and cars. Capital allowances can be claimed on cars used in the property business, but only if the simplified expenses systems have not been used to calculate the amount that can be deducted in respect of running costs.
Practical tip
To ensure that relief for expenditure is obtained in the correct manner, make sure that the expenditure is correctly identified as revenue expenditure or capital expenditure.
