Meg Saksida reviews the classification and clears up some common confusion.
Is it a capital or an income expense? This is a question that is commonly asked when calculating a tax computation for a let property.
Important distinction
Why is it so important to know the difference? Because if the cost is an income expense, it can be deducted from the rental profits and will therefore lead to less income tax being paid. The tax reduction is immediate, as the deduction can be made in the same tax year as the expenditure. The deduction can also benefit from an (up to) 45% tax saving.
If it is a capital expense on the other hand, it will be deducted from the proceeds on the disposal of the asset. It will become ‘enhancement expenditure’ and will be a part of the cost that is compared with proceeds in order to calculate the gain on disposal. The disposal may not occur for many years, and as such the deduction may not be utilised until a long time into the future. Furthermore, the highest capital gains tax rate is 28%, so the maximum tax saving from the expense is (up to) 28%.
The definition of an income expense
To be deducted from rental income, expenses need to be incurred ‘wholly and exclusively’ for the purpose of the business, and not be of a capital nature.
Examples of common income expenses are accountancy, legal, and estate agent fees, advertising and insurance costs, replacement of domestic furnishing and appliances, cost of travel to visit the property (unless any dual purpose evident), repairs and redecoration, interest and other finance costs.
The definition of a capital expense
The most obvious capital expense is the initial purchase of the land and buildings. If a building has been added after the rental period has begun this will also be capital, such as adding a shed or garage on the property.
Furthermore, improvements to the property will be capital. HMRC considers that it will be a ‘question of fact if expenditure on a property leads to improvement’.
Sometimes, small items of expenditure can be classified as a repair, and as such an income expense. For example, the repair of one or two roof tiles would be classified as a repair. The replacement of all the tiles in the form of a completely new roof would, on the other hand, be a capital improvement.
Additional assets
Whether the expense is capital or income is often considered in the context of whether the property now has ‘additional assets’; this can often be quite difficult to establish.
For example, if the property had a standard ‘no frills’ kitchen, and this was replaced with another standard ‘no frills’ kitchen, the property has not benefited from any additional assets. Even if the kitchen incorporated some more modern features such as using more modern materials, greater durability in the work surfaces or soft closing drawers, it would still be considered to have replaced an asset, like for like, that was already in the property. Replacing wooden beams with steel girders or lead pipes with plastic pipes, or single glazed windows with double glazing windows are more good examples of no ‘additional assets’ being introduced despite them being updated for modernity or function.
However, any significant improvement to the asset would constitute an additional asset. Keeping with the example of the kitchen above, if instead of a ‘no frills’ kitchen, if a designer kitchen is installed in the property with several features and a quality, drastically enhanced from the original kitchen; a new asset will have deemed to have been added to the property. Similarly, if the new steel girders take a substantially heavier load, or if the new pipes take considerably more pressure or heat, an additional asset would be evident, and capital expenditure would be in point rather than expenditure deductible from rental income.
Can there be both capital and income expenses for one purchase?
There can indeed be cases where there is an element of capital and income in the one expense. Continuing with our roof example, imagine if the roof tiles were all replaced with a new roof, but the contractor repaired some of the guttering at the same time, issuing one invoice. The cost of the roof would be classified as a capital expense but the guttering repair would be an expense able to be deducted from income.
If there are combined capital and income expenses on the same invoice, they should be apportioned according to the respective elements on a sensible basis.
Repairs made soon after a property is purchased
Landlords need to be very careful about the assignment of capital and income expenses if such expenses are being incurred close after the purchase of a property. It is not controversial that if a repair is being made to an existing property in a rundown or broken state, such expenses are income expenses.
However, if the property has only recently been bought by the landlord, it is important to establish whether the price paid at purchase reflected the dilapidated state.
If the property was not able to be lived in or used in the letting business until such repairs were carried out, it is probable that the consideration paid for the property reflected the need for the repairs and the price was undoubtedly reduced due to this. The cost of the repairs necessary would increase the eventual gain for capital gains tax purposes at a maximum tax cost of 28% while offsetting the expense as a deduction benefiting from as much as 45%. This can be compared to the situation where the vendor had made the repairs themselves before selling the property, where all the cost would be capital.
Two famous and conflicting cases show this principal well; Law Shipping Co Ltd v CIR [1923] 12 TC 621 and Odeon Associated Theatres Ltd v Jones [1971] 48 TC 257. Both companies had purchased an asset that had its price reduced due to repairs that needed to be made. Law Shipping bought a ship and Odeon Theatres bought a cinema. The ship could not be used without the repairs having been made, but the cinema was still functioning despite the need for the repairs. Law Shipping were not allowed to offset the repairs from their income. The company had to add them as a capital cost increasing the cost of the asset for the future gain. However, Odeon Theatres were able to offset the repairs as a deduction against income.
Practical tip
The split between capital and income expenses is not only administrative but can make a real difference to the amount of tax saved on the deduction either at income tax or capital gains tax rates, and also on the timing of when the tax deduction is received, either in the current tax year for income expenses or at the point of the sale of the asset for capital expenditure.
Although it is tempting to allocate more expenses to income due to higher tax rates and quicker access to the deductions, they must be allocated correctly to ensure no penalties for errors occur in later years.
