LANDLORDS – CAPITAL V REVENUE EXPENSES
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The difference between capital and revenue is still very much a grey area for many landlords across the UK. But if you let out properties, it’s vital you understand the differences by the time your tax bill arrives or you could be in for a shock.
How can you tell the difference?
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Capital expenditure is considered the cost of gaining or improving an asset over a longer-term. In IR150 para 180, of the ‘Taxation of Rental’ manual, it says the following: “Costs you incur in obtaining loan finance for your rental business are generally deductible in computing rental business profits provided they relate wholly and exclusively to property you let out on a commercial basis. These costs include loan fees, commissions, guarantee fees, and fees in connection with the security of a loan.”
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This, therefore, means that a) and b) are classed as revenue expenditures and can therefore be offset against the rental income.
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Property valuation costs on the other hand are of a ‘capital’ nature. The following paragraph from ‘Taxation of Chargeable Gains Act 1992’ proves this to be the case
This is usually a one-off purchase and helps to improve the position of the business overall. Capital expenditure may include:
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Purchase costs
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Delivery costs
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Installation charges
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Replacement costs
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Upgrade costs
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Legal charges
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Stamp Duty
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Search Fees
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Valuation Fees
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Source Fees
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Installation of a new central heating system where one was not present previously.
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Additional rooms or extentions.
Revenue is considered a recurring expense that maintains the position of your business. The effects of the purchase are only temporary, which is why they must be done regularly. This could include:
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Repair costs
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Maintenance charges
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Renewal expenses
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Repainting costs
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Broker Fees
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Mortgage arrangement fees (In IR150 paragraph 180), of the ‘Taxation of Rental’ manual it says the following: “Costs you incur in obtaining loan finance for your rental business are generally deductible in computing rental business profits provided they relate wholly and exclusively to property you let out on a commercial basis. These costs include loan fees, commissions, guarantee fees and fees in connection with the security of a loan.”
The government have their own capital vs revenue toolkit to provide guidance on reporting expenditure in self-assessment forms and company tax returns, which you can see by clicking here.
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Speak to Karia Accountants Ltd for help filling out your tax return, or for any further advice regarding capital and revenue expenses
How does it affect your tax bill?
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If an expense falls under ‘revenue’, you can receive income tax relief on it. These costs are frequent and necessary to maintain your property, but the cost will lower your profitability overall.
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‘Capital’ expenses involve replacing or renovating your current assets and do not qualify for income tax relief. That is because you will only benefit from the work when you come to sell the home, which will then be considered a claimable expense for capital gains tax.
The way this works is that when you sell a residential property that is not your home, you’ll have to pay 28% capital gains tax on the profit you make from the sale. You will have to declare this on your self-assessment for and, from April 2020, you’ll only have 30 days from the sale of the property to make this payment to HMRC.
Renovating derelict buildings for renting
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Many first-time landlords assume that paying out on making a property habitable before their tenant moves in counts are revenue expenditure. However, this kind of work is technically a one-off improvement – making it a capital expense.
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Unless the building is falling apart, derelict, or just very run down, the cost cannot be considered revenue expenditure. And this can be extremely difficult to prove.
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HMRC holds strict guidelines as to what counts as genuine revenue to stop people potentially abusing or manipulating the system. If not, landlords could claim all of their work to be revenue and claim tax relief on it, costing HMRC millions of pounds.
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It is extremely likely that HMRC will disagree with your initial interpretation and reclassify the expense as capital.
Even with run down properties, you would not have been given a mortgage on the property if your mortgage provider did not think it was suitable to live in. Your surveyor may have indicated parts which needed updating, but if your mortgage is accepted then you could argue the property is fit to let out from day one.
Anything you repair or replace that is not fit for purpose may be considered revenue spending. On the other hand, the things written in your surveyor’s report that require ‘updating’ will be classed as capital expenditure so you won’t be able to claim deductions.
A luxury or a necessity?
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Another way to tell the difference between the two is to ask yourself – is this expenditure a necessity or a luxury? The lines between these may be thinner than you first think.
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The HMRC’s property income manual states that replacing outdated technology, where it is not practical to replace the individual parts of the asset, will be considered an allowable expense.
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For example, the manual says, “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.”
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It goes on to state that replacing single glazed windows for double-glazing counts as revenue spending. “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.”
As they are now the standard, double-glazed windows can be considered a necessity; especially those buying or renting from you. The limit lies where this crosses over into a luxury expense – for example replacing an old fashioned but functioning sunroom into a modern, top of the range conservatory.
The roof test
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This luxury/necessity argument in regard to capital and revenue can be seen in the HMRC’s roof test.
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Say the roof of your buy-to-let property is damaged. If it consisted of cheap asphalt shingles prior to the damage, you could replace them with similar cheap asphalt shingles and be able to claim tax relief on the expense.
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However, replacing the cheap originals with new, expensive tile shingles then it would count as capital expenditure.
The kitchen test
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According to the HMRC’s manual, if you ripped out the old kitchen in your property and replaced it with a similar, modern equivalent, the repair and expenditure would be “allowable.”
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However, if you chose to replace it with “expensive customised items using high-quality materials, the whole expenditure will be capital”.
Replacing the kitchen with a comparable model may not always count as revenue though. If you fit additional cabinets, increase the storage space or add extra equipment, the manual says “this element is a capital addition and not allowable (applying whatever apportionment basis is reasonable on the facts)”.
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Please also be advised that not having a breakdown of the costs, or knowing where the money was spent is not a reasonable excuse accepted by HMRC. It is important to distinguish correctly between capital and revenue expenses.