Tenant Dilapidation Payments – Income Or Capital?

 

Some tenants treat the residential property they rent with great care. Unfortunately, others do not, and the landlord may receive dilapidation payments from the tenant to enable the landlord to restore the property to its former condition at the end of a tenancy.

 

The question arises whether such a dilapidation payment should be treated as income in a similar way to rent in the landlord’s property rental business, or whether it is a capital receipt in the landlord’s hands and subject to capital gains treatment.

 

In the recent case Thornton v Revenue and Customs [2016] UKFTT 767 (TC), the taxpayer received rental income from 18 flats leased to a housing society under a tenant’s repairing lease, whereby the tenants were responsible for the upkeep of the flats. However, they did not do so. The flats were latterly vacant for at least a year, as they were unfit for habitation. The housing association continued to pay rent to the taxpayer whilst settlement negotiations were conducted to end the housing association’s liability under the lease, so that the taxpayer could recover the flats to prevent further disrepair. A settlement was subsequently reached and the taxpayer received £250,000 in July 2010. The receipt was not included in the taxpayer’s profit and loss account for the year ended 31 August 2010 but was reflected in the balance sheet in the rental accounts as a creditor.

 

Following an enquiry into the taxpayer’s tax return for 2010/11, HM Revenue and Customs (HMRC) considered that the settlement should be treated as an income receipt. The taxpayer appealed. The First-tier Tribunal considered (following London and Thames Haven Oil Warves Ltd v Attwooll (Inspector of Taxes) [1967] CH 772) the issue to be the source of the legal right resulting in the taxpayer receiving the payment from the housing association. It found that the legal right derived from the lease and subsequent negotiations. 

 

The tribunal considered that the nature of the liability was to make good the fall in capital value attributable to (and calculated by reference to) the dilapidations that the tenant had failed to make good. When the lease was terminated, due to the inaction of the housing association, the taxpayer had suffered a permanent diminution in the capital value of his investment, and the settlement was to make good that loss. The tribunal concluded that, in the circumstances, the receipt should be regarded as capital in the taxpayer’s hands. 

 

HMRC’s guidance on the tax treatment of dilapidation payments by tenants to landlords (in its Property Income manual, at PIM2020) indicates that the tax treatment of such payments will depend on the particular circumstances. 

 

For example, if the landlord subsequently disposes of the property or occupies it himself, HMRC accepts that the payment is likely to be treated as a capital receipt as compensation for failing to observe the terms of the lease, as a result of which the property reverted to the landlord in a dilapidated condition. 

 

However, if the payment is likely to have the effect of ‘filling a hole in the landlord’s profits’ in terms of compensating the landlord for the lower rent the property can now command, HMRC considers that the payment should be treated as a receipt of the rental business. Alternatively, if the tenant pays a sum towards the cost to the landlord of carrying out the repairs required, in HMRC’s view the landlord should be able to claim a deduction for the net cost he bears.

 

In Thornton, the flats reverted to the landlord, but HMRC argued that the payment should be treated as an income receipt on the grounds that it covered the loss of rental income due to the dilapidated state of the properties. However, the tribunal noted that the landlord spent all of the payment and more on repairs, and concluded: 

 

‘Shortly put, we have identified that the nature of the liability in this particular case was to make good the fall in capital value attributable to, and calculated by reference to, the dilapidations that the tenant had failed to make good. When the lease was terminated, due to the inaction of [the housing association], [the taxpayer] had suffered a permanent diminution in the capital value of his investment and the settlement was to make good that loss.’

 

Landlords should keep contemporaneous records in support of the factors resulting in dilapidation payments from tenants. The tribunal in Thornton considered that the case was not wholly in point with any case law authorities on the distinction between income and capital and was decided on the particular circumstances, so evidence may be important in establishing the tax treatment of such payments.