Lee Sharpe looks at some tax issues arising from converting a standard dwelling into a house in multiple occupancy.
Liz has recently been made redundant from a high-flying career in politics. With a substantial sum burning a hole in her pocket, she decides to try her hand at property investing. After several hours of diligent internet research, she concludes that houses in multiple occupancy (HMOs) offer the best bang for her buck; the possible returns are amazing!
She acquires a substantial property as a single-dwelling household previously occupied by its owner as a private residence. She enlists the help of an architect to plan the conversion from three very large bedrooms into six private bedrooms, now sharing the original two bathrooms, kitchen and two living rooms.
The builder
Liz talks to a builder who has some experience of dealing with her local authority and warns her that HMOs in the area must include (amongst other things):
- all bedroom doors, ceilings and partitions fire-rated to 60 minutes;
- upgraded electrical systems; and
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a fire alarm system.
In terms of more general building work, Liz intends to:
- gut and replace the kitchen, with more storage units, an extra cooker, dishwasher and fridge;
- re-do both the upstairs and downstairs bathrooms; and
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paint, decorate and re-carpet throughout.
The builder suggests that the property will also need a new, significantly larger boiler to handle the new layout, replacing the old boiler in the kitchen.
The builder is VAT-registered and initially quotes £120,000 for all the work, including 20% VAT as standard. Liz asks around and finds a second builder who is not VAT-registered and offers to do the work for £110,000. When Liz goes back to the first builder and says he is too expensive, the first builder has good news:
“I have checked with my accountant, and she tells me I can charge you only 5% VAT because HMRC treats a house-to-HMO conversion as changing the number of dwellings in a property, so only 5% VAT is chargeable. The revised quote is £105,000” (see, for example, VAT Notice 708).
He adds: “If the VAT registration threshold is £85,000, how can the other guy not be VAT-registered but charge you £110,000 for about four months’ work?” Liz decides to engage the first builder after all.
The adviser
While out shopping, Liz bumps into her accountant and, in passing, mentions that she’s had a large lump sum but won’t need to pay any more tax because she’s investing it all into a new HMO property. Her accountant recommends a meeting to discuss the project, and Liz reluctantly agrees. During the meeting, Liz’s accountant explains the following:
Liz’s redundancy payment, under employment income, does not automatically get reduced by investing it into a new business; it is taxable under separate rules (although genuine redundancy payments may enjoy special status).
Also, the cost of converting the property will not all be allowable immediately to create a large rental business loss (and in any event, personal rental losses can usually be applied only against future property profits, not other sources). Some of the expenditure will amount to repairs, which does reduce property profits; some of the expenditure will amount to capital, which does not – becoming part of the value of the property itself.
The bad news
Taken aback, Liz argues that surely the construction costs must be allowable – otherwise, she would not be able to let the property and generate income. Unfortunately, it’s not that simple, as Liz’s accountant explains:
“Just because you must spend money for the business does not mean it has to be allowable. You had to buy the property in the first place, and that’s capital. Improvements to the property are also capital.
Where you are repairing or maintaining the property, that is OK – that is deductible.”
Liz is really worried now; how can anything not be an improvement? How does anyone ever get tax relief for any property work? Liz’s accountant explains:
“You’re actually luckier than most. Unlike with ordinary buy-to-let properties, there are things that still get tax relief, even if they are strictly capital. This is because you can claim capital allowances – in some parts of an HMO property – whereas most BTL landlords cannot claim capital allowances in their rentals. You can even claim 100% annual investment allowance in many cases, where capital allowances are available, so that you get all the cost back in the first year.”
So, Liz asks where these magical areas are. It turns out that the bedrooms and communal living spaces (kitchen, bathrooms, living rooms) are out as parts of the dwelling, leaving only the porch, hallway, stairwell, landing, etc.
Liz is actually beginning to feel rather unlucky and wonders if maybe her accountant secretly works for HMRC. She wouldn’t be spending all this money if it weren’t on improvements – the old bathrooms were a mess! How can she say they’re just repairs?!
Some good news?
“Ah, that may be easier than you think. It doesn’t matter if the original fixtures are old and tired. What matters is if you’re going to replace the fittings with things of higher quality, compared with when the old stuff was brand new. Replacing one middle-of-the-road shower with another new middle-of-the-road shower gets you an allowable deduction. But replacing a normal-quality bath with a jacuzzi is a capital improvement.
Turning to the kitchen, where you replace old cupboards with units of similar quality to the old ones as originally fitted, that’s likely a repair and deductible from rental profits but if you install better (or extra) units or white goods, they are likely capital improvements and such costs will have to be set aside.”
Liz chews this over for a bit. OK, that makes some sense. But what about the mandatory work?
“Well, certainly, if it must be to a higher standard than before, then it’s likely capital, and there’s no immediate deduction. So, structural work in general (e.g., any special electrical work in the kitchen and bathrooms, etc., the bedroom doors and the fire-rated additions) looks like capital costs – as well as any corresponding making-good. But your other general painting and decorating will still be OK.
Also, keep in mind that most of the expensive parts (i.e., control panels, switchboards and similar) will probably be in the hallway and landing areas, so even if they are capital improvements, you may well be able to get capital allowances on those as they’re not inside the living areas.
But that new boiler is a pain; you’ve deliberately gone for a higher capacity, so it looks like an improvement, and it doesn’t help if it’s in the kitchen – as a living area. And it was not cheap. Hold on, though; wouldn’t it make more sense, if you really want to maximise storage in the kitchen, to put a couple of extra units in place of the old boiler, and relocate the new boiler slightly to (say) under the stairs in the hallway? You might then be able to claim capital allowances on the cost of installing that as well.”
A happy ending
Reassured that she was right about HMOs after all, Liz practically skips out of her accountant’s office, plotting her next purchase.
Her accountant makes a note that Liz should elect out of the property cash basis in her tax return so that she can actually claim capital allowances and maybe then even claim some losses against her other income as a result; and then offers a quick prayer to the gods of tax that Liz doesn’t take a shine to commercial property next.
Conclusion
In practice, the accountant is usually informed long after the building phase is over. Also, the taxation of real redundancy payments is generally more complex (and more taxed-at-source). Those set-aside capital costs are not entirely useless and should be recorded; they may still save up to 28% capital gains tax if and when the HMO is sold.
It is not Liz’s job to check if her builder should be VAT-registered, but if an unregistered builder were halfway through the project and then had to register and charge VAT, Liz might have to pay extra rather than demand the builder pay it out of the original fee, or risk the builder walking away.
