Tax and refurbishing residential properties
In this article, we shall look at a case study to illustrate the ‘capital versus revenue’ divide in the context of repairs to residential property. This is a common sticking point for landlords and their advisers.
Generally, securing relief for income tax is preferred, as it results in an immediate deduction against in-year profits, rather than having to wait until a capital disposal occurs. References are to HMRC’s Property Income manual (PIM) or Business Income manual (BIM), but will largely hold good whether for income tax or corporation tax.
Key principles Significant repair expenditure on the acquisition of a new property does not mean that the expenditure must be capitalised:
a) Where replacing part of an asset, it is an improvement only if: i) the replacement is of inherently better quality than the original part when the latter was originally installed; or ii) There are additions over and above the original installation.
b) You can make allowances for the use of modern techniques or materials.
c) It is perfectly acceptable to split an overall project cost between elements which are repairs on revenue account, and capital improvements.
However, just because a cost is essential does not necessarily make it immediately deductible.
Relief for capital improvements is available on capital disposals only if the asset/improvement is still around at the point of disposal.
The rules for residential property repairs are quite different from commercial property. Broadly, with residential property the property itself is taken to be ‘the asset’ and replacing a kitchen is a repair to the property asset from a tax perspective. With commercial property, replacing a kitchen would involve replacing discrete capital assets (units, appliances, etc.) subject to capital allowances. For more on identifying the asset in this context, see BIM35435.
Case study: Revenue or capital expenditure?
Nat acquires a new residential 3-bedroom property for the purposes of letting, for £250,000. It had been occupied as a private residence to the point of sale, so was clearly habitable, but was ‘in need of some modernisation’ as the previous owners had done little to maintain it for well over ten years. Nevertheless, the price of the property had not been significantly discounted when compared to similar properties in the area.
Nat wants to make sure that the property will be capable of being let comfortably for a good number of years before anything more than spot repairs are required. The loft space has been boarded out and wired but could not formally be sold as a fourth bedroom because it did not comply with the relevant building regulations at the point of sale. After the survey, the following schedule of works is set out:
Electrical works generally to bring up to code - £5,000
New kitchen; replace units and appliances, different layout, additional units in pantry - £15,000
New cloakroom facilities – replacing largely as before - £5,000
New main bathroom – replacing suite but also adding a separate shower and enclosure, rather than over bath as current - £10,000
Re-plaster internal walls - £5,000
Redecorate throughout - £5,000
Replace carpets throughout - £2,500
Fix stairs to loft, additional wiring, plumb for en-suite bathroom, additional Insulation to bring up to regulations - £17,500
Total expenditure £65,000
Notes The wiring in many parts of the property needs replacing. Nat wants additional power outlets in most of the rooms, which would of course comprise improvements. While the new wiring system is to a significantly higher standard than it replaces, it is nevertheless only up to the standard required for a modern domestic installation, so it is inherently a repair. If (say) the local authority was to insist on a higher standard because it was about to be let out, the re-wire would probably be an improvement.
However, if the building had been sold to Nat as an established residential letting, it might arguably be a repair again, albeit to a higher modern standard for lettings. There are 14 additional sockets throughout and the electrician charges £50 per socket, so Nat disallows £700 as improvements.
The kitchen is, of course, much improved on what it replaces, but when compared to the quality of the ‘old’ kitchen when it was originally installed, it is of a similar quality, so is a repair. Here again, the plumbing and electrical works may well be to a higher standard than they were 15 years ago, but they are still only as required for a standard domestic installation. See HMRC’s ‘Refitting a Kitchen’ example at BIM46911. However, the additional units in the pantry are clearly a capital addition; Nat disallows 10% of the overall cost to cover the cost of the pantry units and their fitting, etc. (see PIM2030), so £1,500.
The cloakroom is a repair; so no disallowance.
Here again, the bathroom is much better than the ‘old’ bathroom but not in terms of inherent quality when compared ‘as new’; however, adding a separate shower stall is a capital addition, rather than a relocation. Nat re-uses the old shower appliance, so its cost is not part of the overall separate shower improvement; when it is replaced at some point in future, it may well be a repair in its own right. If Nat had decided to keep the old bathroom but merely add a shower unit, any re-plastering or tiling in the bathroom to make good would have been attributable only to the improvement so would comprise part of the capital cost. Nat disallows £1,500 for the shower stall plus fitting/plumbing.
Re-plastering, repainting and redecorating often go hand in hand with re-wiring a property or major refurbishment project generally. On the basis that such works insofar as they relate to specific improvements (pantry, bathroom, loft) are costed in (2), (4) and (8) already, no disallowance is required here.
As for (5).
Broadly as for (5) but actually under replacement domestic items relief for carpets; see PIM3210.
Bringing the loft space up to required regulations is an improvement. The loft space may be physically habitable as a bedroom but additional work is required to bring it up to a manifestly higher standard than its original use (note it could not be marketed to Nat as a bedroom at the point of purchase). There may arguably be an element of repair to some of the work involved, but repainting, etc., following improvement is considered part of the improvement (see BIM46915). Nat disallows the full cost of £17,500.
Are you with us so far?
Current regulations broadly require that a three-storey dwelling has door-closers and/or fire-rated internal doors to slow the spread of fire, etc. These would rank as improvements. Door closers in particular have a habit of ‘disappearing’ soon after passing building inspection.
Putting to one side the risks to personal safety and criminal sanction, the corresponding expenditure will not be allowable for CGT purposes if the improvement (as repaired or replaced over the years thence) is no longer present at the point of sale.
Summary The total program cost of £65,000 is more than 25% of the cost of the building itself. But disallowed improvements account for only £21,200 of the spend. Note that only the work on the loft is likely to make a significant difference to the property’s market value; a few years down the line, the other repair works will have a negligible effect.
Ideally, the improvements to the loft space, extra sockets and work in the pantry would be treated in the accounts as capital improvements, so they would automatically be included as costs to set against future capital disposals. The tax review should be undertaken before the accounts are finalised. But the accounts treatment follows different rules and will not always happily align, so supporting permanent notes are practically always needed.
HMRC has extensive guidance on repairs and capital v revenue expenditure, which is largely helpful, but unhelpfully organised. See:
PIM2020 et seq.
BIM35430 et seq.
BIM46900 et seq.
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