If you are carrying out repairs to a dilapidated property, this may be treated as capital expenditure rather than revenue expenditure. Brona MacDougall explains the position regarding tax relief.
Buying a property and doing it up for letting out can make good financial sense, however, repairs and renovations are expensive, so it is important to ensure that tax relief is obtained wherever possible. But the way in which tax relief is given depends on the nature of the expenditure.
What is a ‘repair’ and what is an ‘improvement’?
HMRC defines a ‘repair’ as the restoration of an asset by replacing parts of the whole asset. For example, they cite replacing a few roof tiles which were blown off in a storm as an example of a repair.
Examples of common repairs include:
• exterior and interior painting and decorating
• stone cleaning
• damp and rot treatment
• mending broken windows, doors, furniture
• mending machines, such as cookers or lifts
• replacing roof slates, flashings and gutters
However, there is a distinction between a ‘repair’ and an ‘improvement’. A repair is a like-for-like replacement that restores the asset to its original condition. Work undertaken on a property is not regarded as a repair if there is a significant improvement of the asset beyond its original condition, this will instead be deemed as capital expenditure.
Revenue deduction for repairs
Repairs, as distinct from capital improvements, are revenue items and where they are incurred wholly and exclusively for the purposes of the business, are deductible in computing the profits of that business. This means that relief is given in full and is immediate, it is given in calculating the profits for the period in which the repair expenditure is incurred.
In contrast, capital expenditure cannot be deducted in computing the profits of the business. Unless the accounts are prepared under the cash basis and the expenditure is of a type which a deduction is permitted under the cash basis capital expenditure rules. Relief is, instead, given under the capital gains tax rules, unless (rarely) capital allowances are available.
Dilapidated buildings present a particular challenge in deciding whether work constitutes a repair or an improvement. In its guidance on determining whether a repair is a capital item, HMRC provides a list of examples of capital expenses. That list includes ‘the cost of refurbishing or repairing a property bought in a derelict or run-down state’.
The question is, does this mean that any work undertaken on a dilapidated property is capital rather than revenue? The answer to that is not necessarily, but it is essential to consider in detail the nature of the work. It is important to remember that repairs may be undertaken at the same time as capital improvement work, and the fact that there is also capital improvement work does not stop a repair from being a repair.
In guidance, HMRC states: ‘repairs to reinstate a worn or dilapidated asset are usually deductible as revenue expenditure’, pointing out that the fact that the property was purchased not long before the repairs were undertaken does not in itself make the repair a capital expenditure.
However, the purchase of a dilapidated property combined with other factors might mean that the expenditure falls on the capital side rather than on the revenue side.
Property not in fit state to be used for business
Where a property is acquired in a state that means it is not fit for use in the business until the repairs have been carried out, the work will generally be deemed capital rather than revenue.
Where a dilapidated property is purchased with a view to being used as a rental property, the property will need to be brought up to a habitable condition before it can be let out. Consequently, the work is regarded as a capital improvement rather than as a revenue repair.
Price substantially reduced
A dilapidated property will usually be cheaper than a similar property in a good state of repair; the price of the property reflects its condition. Where the price paid for the property is substantially reduced because of its dilapidated state, and repairs are undertaken shortly after acquisition, the cost of those repairs will generally be regarded as capital rather than revenue.
The cost of buying a property in a good state of repair is capital expenditure. Consequently, the cost of buying a dilapidated property and the cost of putting it in good order is also regarded as capital expenditure.
However, this rule does not apply where the purchase price simply reflects the value of the property due to normal wear and tear. In this situation, HMRC accepts that repairs made shortly after acquisition are revenue rather than capital expenditure. This may be a case where the price reflects that the property needs redecorating. Where this is the case, the costs of redecoration would be a revenue expense.
In practice, it can be difficult to ascertain where the dividing line between a property that has suffered normal wear and tear and one that has become dilapidated falls.
If there is not already a property letting business and a property is purchased in a dilapidated state to be let out once the renovation work is complete, any repair expenditure that would be deductible as revenue expenditure had the business commenced is allowable under the pre-letting rules if incurred in the seven years prior to the start of the property letting business.
The allowable expenditure is treated as if it were incurred on the date on which the property income business commenced.
Relief against capital gains
The fact that work undertaken to make a dilapidated property habitable may not be deductible as a revenue expense does not mean that no relief is available. Instead, relief is given for capital gains tax purposes when computing the gain or loss on sale.
As the property may not be sold for some time, it is important to keep good records of the expenditure incurred on doing up the property so that the cost of the improvements is not overlooked when the property is eventually sold.
Repairs undertaken on a dilapidated property to bring it up to a habitable standard are capital in nature rather than revenue. While these expenses cannot be deducted in computing profits, they can be deducted in working out the gain or loss when the property is sold.