Sarah Bradford considers the extent to which tax relief is available for the costs of renovating a property.
Buying a property to renovate can be appealing for a number of reasons. For example, there is the possibility of making a profit from ‘doing it up’, as well as the chance to put your unique stamp on a property.
However, such a venture can be expensive, and it is prudent to ensure that you obtain any tax relief that is available for the associated costs.
Trading or investment?
Before looking at the available tax reliefs, it is necessary to consider the renovator’s intentions.
For example, are they buying the property in the hope of making a quick profit, is it a home, or are they planning to let it out once renovated, either as a residential or holiday let?
Renovating an investment property
If a property is bought as an investment property and the intention is to let it out once renovated, tax relief may be available for the renovation costs.
A property rental or furnished holiday let business starts when the property is first let out. However, where a property is purchased as a renovation project, the costs of renovating the property will usually be incurred prior to the first let.
When it comes to claiming tax relief, this will not usually be a problem, as there are special rules that deal with pre-commencement expenditure, which allow a deduction incurred in the seven years prior to the start of the business for expenses that would be deductible if incurred once the business was up and running. The expenses are treated as if they were incurred on the day that the property business commenced, with relief being given in working out the profits of the first accounting period.
Revenue or capital expenditure?
When deciding whether relief is available for the costs of renovating a property, a distinction is drawn between revenue expenditure and capital expenditure. In a renovation context, this will usually mean determining whether the work that is being undertaken is a repair or an improvement.
Expenditure on repairs is revenue expenditure, which can be deducted in calculating the profits of the property rental business or furnished holiday let, to the extent that the expenses are incurred wholly and exclusively for the purposes of the business. Repairs would include costs like replacing roof tiles that had blown off, repairing windows, repointing, and painting and decorating.
By contrast, expenditure that enhances or significantly improves the property (e.g., the building of an extension or a loft conversion, or removing a wall and installing bi-fold doors) would be capital expenditure rather than revenue expenditure.
However, where the improvement element is small or arises simply as a result of better or more modern materials being used, HMRC will accept that the expenditure remains revenue in nature, for which a deduction is permitted, rather than capital expenditure. In particular, HMRC accepts that the cost of replacing wooden beams with steel girders or lead pipes with copper or plastic pipes will be revenue in nature rather than capital.
In a renovation project, capital work and revenue repairs may be undertaken at the same time. In this situation, relief will remain available for the revenue expenditure to the extent that it can be identified separately. Where work is undertaken comprising both enhancement and repair, it is prudent to obtain a detailed invoice so that the different elements can be quantified. However, HMRC will accept an apportionment on a reasonable basis.
Relief for capital expenditure against profits is limited; the relief is given by reducing the gain when the property is sold. However, the rules on capital expenditure differ depending on whether accounts are prepared under the cash basis or the accruals basis. Where the property business is an unincorporated property business, the default basis is the cash basis where the landlord is eligible to use it (which will usually be the case where rental receipts are £150,000 a year or less). If the landlord is not eligible to use the cash basis or elects not to do so, the accounts must be prepared using the accruals basis.
Under the accruals basis, only revenue expenses can be deducted. However, under the cash basis, capital expenditure can be deducted in computing profits unless it is of a type for which a deduction is specifically prohibited. Unfortunately, the list of capital expenditure for which a deduction is denied includes expenditure on altering the property, and that on the provision, alteration or disposal of an asset for use in a rental property.
While no relief is available for the initial cost of domestic items, the cost of replacement domestic items can be deducted.
Relief for borrowings
Renovating a property is expensive, and the landlord may need to borrow money to finance the renovations. Where the property is let as a residential let, relief for finance costs (e.g., mortgage interest) is given as a tax reduction at the rate of 20%.
However, these rules do not apply to furnished holiday lettings, and interest costs can be deducted in full when working out the taxable profit.
Keeping track
It is important to keep records of the cost of improvements so that these are taken into account in calculating any capital gain on the eventual disposal of the property.
The cost of improvements is part of the allowable cost, and in this way relief for the expenditure is given through the capital gains tax system at the relevant rate (currently 18% or 28%).
Renovating a home
A person may also buy a property to live in as a home and renovate it, either while living it in or prior to moving in. There is no tax relief for the revenue costs incurred in ‘doing up’ a home, but when the property is sold, main residence relief will shelter any gain to the extent that the property has been the owner’s only or main home during the period of ownership, plus the final nine months of ownership.
If the owner buys the property and does not live in it until the renovations are complete, the period from the date of acquisition to the date it is occupied as a main residence will not be covered by the main residence exemption. Where this is the case, it is important to ensure that records are kept of capital expenditure so this can be taken into account when working out the eventual chargeable gain.
Is it a trade?
A property developer will usually be looking for a quick turnaround. The intention here is to buy a property in need of work, with a view to undertaking that work such that the property can then be sold at a profit. A property trader may have several projects on at the same time; however, a person can still be a trader if they are only renovating one property.
Where there is a trade, normal rules apply to determine the extent to which expenses are deductible. Consequently, in calculating the trading profit, expenses can be deducted to the extent that they are revenue in nature, and wholly and exclusively incurred for the purposes of the business. Costs that fall into this category include finance costs such as mortgage interest (note that the restrictions on relief applying to residential landlords do not apply here), the cost of repairs and maintenance (but not improvements and enhancements) and the usual revenue expenses incurred in running a business, such as wages, office costs, travel expenses and suchlike.
Relief for capital expenditure is limited; capital allowances are available for certain integral features, such as electrical and lighting systems, cold water systems, space heating, lifts and external solar shading.
When the property is sold, the profit is taxed either to income tax (where the developer is running an unincorporated business) or to corporation tax. A self-employed individual will also be liable to Class 2 and Class 4 National Insurance contributions.
Stamp duty land tax
Finally, a mention of stamp duty land tax (SDLT) is worthwhile. As the recent tribunal decision in Bewley v HMRC [2019] UKFTT 0065 (TC) confirmed that where a property is uninhabitable, SDLT is payable at non-residential rather than residential rates. This means that the 3% second property supplement does not apply either.
However, HMRC takes a harsh line on what counts as uninhabitable – in the Bewley case, the property in question was dilapidated, had no heating, bathroom or kitchen, and asbestos was present. `Uninhabitable’ in an SDLT context means more than dated décor and an unpalatable colour scheme.
Practical tip
Keep a record of all costs when undertaking a renovation project to ensure that the available tax reliefs can be claimed.
