Capital versus revenue for landlords – now, this is a topic that’s been causing a lot of debate and disagreements with HMRC for over 20 years now.
However, if you let out properties, it’s one of the most important things you need to know about because it has a direct effect on how much profit you make and the tax you pay upon it.
Smart Team tip – capital versus revenue for landlords also includes commercial landlords.
Capital versus revenue for landlords – what’s it about?
If expenditure is classed as “revenue”, you receive income tax relief on the expense as it reduces your level of profitability.
An expense is “revenue” if it repairs or replaces part of an asset.
If you spend money on your rental property and it is considered as “capital”, no income tax relief is available. You’ll only benefit when you come to sell the home as it will be considered as a claimable expense for the purposes of capital gains tax.
Smart Team tip – when you sell residential property which is not your main residence, you pay 28% capital gains tax on the profit you’ve made. From April 2019, you must make this payment to HMRC within 30 days of the sale of the property. For now, you declare your capital gain on your self-assessment.
An expense is considered as “capital” if it improves or replaces an entire asset.
Seem straight forward enough? When there are well over one million buy-to-let landlords trying to claim as much relief as possible, HMRC don’t see it as straight forward. They’ve been concerned for years that the system has been routinely abused and manipulated.
Capital versus revenue for landlords – doing up a derelict property so that it’s fit for renting
Many landlords often believe that, if they spend money on a property to make it “habitable” (by their subjective standards) before their first tenant arrives that this would be classed as revenue.
That’s not necessarily the case. Unless the property was derelict, very run-down, or in a severe state of disrepair, the expenditure will be classed as capital.
Proving that the expense is revenue is going to be difficult. HMRC will almost certainly initially disagree with your interpretation and reclassify the expenditure as capital.
There is another way to approach it. The key to it will be the surveyor’s report carried out on the property.
It works like this. You wouldn’t have got your mortgage on the property if the mortgage provider believed that the property was not fit to let out. The surveyor may have made notes in his or her reports indicating what needed updating but, overall, the mortgage company were happy to lend you the money even with those caveats.
You could therefore argue that the property was fit to let out on the day you took ownership of it. The elements that you’ve spent money on that were not in the surveyor’s report were revenue spending because you were repairing or replacing something that was no longer fit for purpose or for which there was a modern technological replacement available.
The parts mentioned on the surveyor’s report that needed “updating” would be classed as capital.
So, if your surveyor said that the house needed re-wiring and the kitchen replacing, you would class them as capital. Everything else that was not mentioned in the surveyor’s report would be revenue. It’s not a 100% win but it will allow you to claim some level of deductions.
Keep your builders’ receipts and make sure that on the description of the works shown on the invoices, your builder goes into detail.
Smart Team tip – if you’re converting a property into an HMO, this will always be classed as capital.
Capital versus revenue for landlords – out with the old, in with the new
HMRC reference this themselves in their own property income manual. If technology has moved on and it is not practical to replace part of an asset like for like, it will be allowed as an expense.
To quote, “An example is double-glazing. In the past we took the view that replacing single-glazed windows with double-glazed windows was an improvement and therefore capital expenditure. But times have changed. Building standards have improved and the types of replacement windows available from retailers have changed.
“We now accept that replacing single-glazed windows by double-glazed equivalents counts as allowable expenditure on repairs … Generally, if the replacement of a part of the ‘entirety’ is like-for-like or the nearest modern equivalent, we accept the expenditure is allowable revenue expenditure.”
There are limits though.
A friend of mine was recently staying at a holiday cottage by the sea in Dumfries and Galloway. At the back was a very old-fashioned sunroom which, although functional, looked like it was first installed in the 1970s.
If the owner of that holiday let wished to replace the single-glazed windows in the sunroom with double-glazed windows, that would almost certainly count as an expense. However, if he or she wanted to replace that sunroom with a modern, luxury conservatory or extension, that would be treated as capital.
Capital versus revenue for landlords – the roof test
HMRC accept that, in cases of residential accommodation, the entirety of your asset will be the house or the block of flats.
In their property manual, they mention damage caused to a roof.
Prior to the damage, if your roof consisted of cheap asphalt shingles, it would be a revenue expense to repair the roof with replacement cheap asphalt shingles.
However, if you went the whole hog and replaced your cheap asphalt shingles with the very best tile shingles, you cannot argue that, in HMRC’s words, “the character of the asset remains unchanged.” This work would be classed wholly as capital.
Capital versus revenue for landlords – the kitchen test and splits between capital and revenue
Let’s look at your property’s kitchen, also mentioned in HMRC’s property manual.
As with the roof, if you ripped out your kitchen and replaced it with “expensive customised items using high quality materials, the whole expenditure will be capital”.
But if you replaced the old kitchen with a comparable modern kitchen, “then this is a repair and the expenditure is allowable”.
However, if you were replacing your old kitchen with a comparable modern kitchen but “at the same time additional cabinets are fitted, (you increased) the storage space, or extra equipment is installed, then this element is a capital addition and not allowable (applying whatever apportionment basis is reasonable on the facts)”.
This type of approach will be taken by HMRC on everything you do with your property – what stays the same and what changes for the better?
Smart Team tip – in HMRC’s “Replacement Furniture Relief” guide, white goods like fridges and dishwaters will not be an allowable expense unless they were integrated into the kitchen.
Capital versus revenue for landlords – need the Smart Team’s help?
We’ve tried to provide as much clarity as possible on an area that still often sees the opinions of tax payers and tax collectors diverge.
Call us on 01202 577500 or email us at [email protected].