Meg Saksida looks at when repairs in a newly-acquired property can be offset.
When a landlord purchases a home for letting, there may be work that needs to be done on the property before it is let out. Clearly, all the expenditure on the rental property is wholly and exclusively incurred for the business, but the issue is whether the money spent on the work is allowable as a revenue expense or as a capital expense.
Revenue expenses can be offset in the year they are incurred and reduce the associated revenue, thus providing tax benefits immediately. Capital expenses, however, are classified as ‘enhancement expenditure’ and will be offset as part of the capital gains tax calculation on the disposal of the property (as long as they are still inherent in the state of the property). This could be some years from the date of the purchase, so most landlords would prefer the work to be classified as a revenue expense.
Capital or revenue?
A lot of the confusion comes from two old and subtlety different cases. The first was Law Shipping Co Ltd v IRC [1924] SC 74. In that case, a ship was purchased in a dry dock. Several repairs were made to the ship immediately after purchase, but these repairs were not able to be offset against revenue expense, but instead, were deemed to be capital in nature. The other case was Odeon Associated Theatres Ltd v Jones [1972] 1 All ER 68. In this case, Odeon had purchased a number of cinemas which had been allowed to dilapidate during the war years. Repairs and renovations made to the cinemas were allowed to be offset from the cinema turnover, being deemed as revenue expenses.
The difference in these cases? The cinemas in the latter case were able to be used from day one. There was also no discount in the purchase price because of the disrepair the cinemas were in. The ship, on the other hand, could not have been used without the repairs and the price had been reduced due to the repairs having to be made. The logic behind this is that had the repairs on the ship been made by the vendors, the price would have increased and the purchaser (Law Shipping) would have had a higher capital cost.
Can repairs immediately after the purchase be classified as revenue expenses?
Yes. However, there are conditions:
- The repairs will need to be genuine repairs and not improvements, such that if there had not been a change of ownership, the repairs would still have been deductible from revenue.
- The works were not carried out to render the asset ‘in service’ or useable. In other words, it was already useable or, in the case of a property, able to be occupied before the works had taken place.
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The price of the property was not lower than similar properties to make up for the fact that the works had to be carried out.
For example, suppose that a buy-to-let property had roof damage due to a storm. The roof was letting the rain in and could not be lived in until the roof was mended. The property had been discounted by £10,000 in comparison to other properties in the area because the roof needed to be fixed. In this case, the roof work carried out by the landlord immediately after the purchase of the property would be classified as capital. This can be compared with a house in the same area with no discount on purchase and a watertight roof, with a tired and dated interior. Works to re-decorate should be able to be classified as revenue expenses since the repairs were genuine revenue expenses rather than capital repairs; the property was already able to be lived in, and the price was not lower due to the tired furnishings.
Is it necessary?
There is sometimes confusion over whether necessary expenditure must be deductible. The requirement to repair, upgrade or install something, even for legal reasons, does not always mean the expenditure is deductible.
Houses in multiple occupation (HMOs) are homes in which at least three tenants live who are not part of one household and share the bathrooms and kitchen. For an HMO landlord, fire doors (for example) need to be installed in certain places. It would be easy to assume that by replacing an existing door with a fire door, a deductible necessary repair or renovation has been carried out and that the expense is a revenue one.
However, this is not always the case. If there are already fire-safe doors in the property, this is simply a replacement and, hence fully deductible for tax purposes. However, if this is the first time the property has qualified as an HMO, the fire door is an improvement on the existing door rather than a replacement. The deduction would be limited to the cost of the replacement of the same kind of door.
Is it of the same standard?
Likewise, even when the same item is being replaced, it may not be deductible depending on what kind of an upgrade (if any) it has received.
For example, if a landlord purchases the property with an oven in the property and this needs to be replaced, it will need to be replaced with the same standard oven with approximately the same features to be fully deductible. If, say, a £150 oven with basic features is replaced by a similar standard oven and, when comparing like for like, the new price of £200 is consistent with the price the previous oven would have been should it have been purchased new now, it will be deductible. However, if the oven was significantly more expensive, with more features costing £500, only £200 would be deductible against the revenue.
HMRC does have sympathy for updates in technology. For example, in its Property Income manual (at PIM2030) HMRC states that wooden beams being replaced by steel girders and lead pipes by copper or plastic pipes would not be an example of a capital improvement, but rather a use of new materials which are broadly equivalent to the old materials. HMRC also mentions that ‘trivial’ increases in performance or capacity should be ignored. For example, a washing machine installed in a property able to take 8kgs rather than 6kgs should not invoke a restriction unless it is substantially better quality overall.
Practical tip
Expenses incurred immediately after the purchase of a property can be offset against revenue by landlords, but care must be taken. Firstly, the landlord must ensure that the property can already be used without the works being carried out and that the price was not discounted because of the planned works. Secondly, only like-for-like repairs and replacements can be made if they are to be offset immediately for tax purposes. If the landlord wishes to purchase fittings of a higher standard, they will need to factor in that the improvement element will be a capital expense.
