Landlords are not a popular bunch. Even the good ones are portrayed as greedy exploiters of tax breaks, all of which has made them an easy target for chancellors as they hunt for new sources of revenue. Hence higher-rate tax relief on mortgage interest has been snatched back, as has the useful wear and tear allowance of 10 per cent of annual rent.
And although working out your taxable profit on a letting business might seem obvious, as in take your gross rental income then deduct all costs, it isn’t. That’s because not all of your costs are allowable, and it’s not always easy to tell which ones are. And it’s trickiest of all when you are starting your letting business.
Some costs are easily identifiable as allowable expenses. For example, your tenants call to complain about a blocked drain. Fixing this is an allowable expense, as is landlord buildings insurance. But what about the cost of getting a flat professionally cleaned before your first tenants move in, or adding a splashback so you don’t have to repaint the kitchen every year or even putting in a new modern kitchen?
First, let’s look at the rules laid down by HM Revenue & Customs (HMRC). Note that for the purposes of this article we are assuming that landlords are UK residents, private individuals rather than companies, the properties being let are in the UK, and are purely residential rather than holiday homes. Note, too, that if you let more than one UK property you have to add together all your income from them and all expenses, and treat the properties as a single business.
If you are married or in a civil partnership, the income received from the property must be allocated according to how the property is owned. So if it’s jointly owned the income split must be 50:50. If it is owned by one person, that person must declare all the income on their tax return. If the property is owned unequally then a Form 17 from HMRC must be completed. If the joint owners are not married/civil partners, the income can be split any way they choose. And in case you are wondering, the answers to our hypothetical questions above are: allowed; not allowed; depends on the kitchen.
Wholly and exclusively for the letting business
To claim an expense against your rental income it must pass a series of tests. The first is that it must have been incurred by you wholly and exclusively for the purpose of the letting business. The fee you pay to a letting agent to find a tenant, for example, is incurred wholly and exclusively, whereas buying a lawn mower that you also use at your own home isn’t. A bottle of bleach used exclusively to clean your rental property in between lettings is an allowable expense, as is paying a plumber to repair a faulty boiler at the rental property. If your property is in a block of flats and there are service charges, these, too, can be claimed against your rental income.
The capital expenditure test
There is a further test that items must pass to secure tax relief: the expense must not be capital expenditure. Capital expenditure is where spending creates an asset of enduring benefit, or when you add something to the property that wasn’t there before. This would include improving or upgrading something that was existing. Putting in a security system, a carbon monoxide detector or central heating which was not there before will fall under capital expenditure, as will the cost of fitting out a new kitchen that’s an improvement on the existing one. These things increase the value of your property and you cannot have tax relief on any/all of the cost. However, if the kitchen being fitted is of the same standard, size and layout, and is put in after your letting business has started, the whole cost can be set against your rental income.
Adding a conservatory to the back of the property or dormer windows in the loft space would fail the test because these would be a capital cost. Instead, costs like this should be deducted from capital gains when the property is eventually sold and the capital gains tax bill is calculated.
Replacing a scorched worktop would be considered a repair not capital expenditure. But if you replace a cheap pine worktop with an expensive marble one, you won’t be able to claim the full cost, only the like-for-like. If you add a splashback to avoid annual redecorating costs, it will be capital expenditure because the splashback wasn’t there before.
Generally installing anything that wasn’t there before will be capital expenditure. However, some improvements that might appear to be capital expenditure will be allowed as costs. The cost of replacing old single-glazed windows with double-glazed ones, even though it’s not like for like, will be allowed because double glazed is the modern minimum legal requirement. It’s an unintentional or unavoidable improvement. Although the new material used might be an improvement, the fact is it is broadly equivalent to the old material used.
Repairs and replacements
Even when an expense is clearly not capital expenditure, it will then need to fit into one of two categories to be an allowable revenue expense. These categories are repairs and maintenance, and replacement of domestic items.
HMRC defines repairs as work that restores an asset to its original condition, sometimes by replacing parts of it. Repairs and maintenance costs can apply either to items within the property, such as a boiler, or to the property itself, for example work on the roof. And they are allowed on a like-for-like basis.
This means you can claim for the cost of fixing a burst pipe plus any redecorating and, for example, flashing, gutters and roof repairs and treating damp are also allowable. You cannot claim for repairs that have been covered by insurance, but you can claim for excess amounts or the parts of the repair work that you have had to pay for yourself.
You can claim for renewing broken fixtures such as baths, showers, sinks and toilets. These are classed as repairs to the building, but they must be like-for-like replacements.
Painting and decorating on the exterior and interior are allowable maintenance expenses, as are mending broken windows and doors, and cleaning carpets.
Replacing a broken boiler falls under repairs to the property. Fitting a new kitchen can be categorised as a repair to the property as long as it’s of the same standard and layout as the old one. Otherwise you will find yourself in capital expenditure hot water.
The replacement of domestic items is exactly that – with the emphasis on ‘replacement’. The initial purchases of furnishings and equipment for the property are not allowed, but their replacement is. The replacement of domestic items relief replaced the wear and tear allowance, but unlike the previous relief, the flat or house does not need to be fully furnished to be able to claim it. There are four sub-categories to this relief to help landlords see exactly what they can claim for:
- Movable furniture, for example beds and freestanding wardrobes.
- Furnishings such as curtains, linens, carpets and floor coverings.
- Household appliances, including televisions, fridges and freezers.
- Kitchenware such as crockery and cutlery.
You must only claim for the real cost of the item to you and the old item must not be available for use in the property. The replacement must be of a similar standard or value. For example, if you replace a bottom-of-the-range carpet you can only claim the cost of replacing it with another bottom-of-the-range carpet. You can buy a better carpet, but the extra cost can’t be claimed. Similarly, if you remove a carpet and replace it with more expensive wooden flooring, you can only claim the cost of a similar carpet.
Expenses that can be both
Some expenses can, in fact, be either capital expenditure, and therefore not claimable, or allowed as a revenue expense. Let’s look at two examples.
A new kitchen can be either capital expenditure or a revenue expense. It all depends on what you put in. If the new kitchen is of the same standard and layout as the old one, you can claim it against rental income. If, however, it’s a higher-spec kitchen, better-quality fittings and/or of a different layout, it will be capital expenditure and is not allowable. The same would apply to a new bathroom.
If you need to extend the lease on your rental property, this will usually be deemed capital expenditure. But if the lease extension is for less than 50 years, it can be claimed as a revenue expense.
There is one huge caveat to all of the above: the tests and rules discussed so far all apply once the letting business is up and running. It’s a different matter when the costs are incurred before your first tenants move in.
The before and after caveat
A particularly blurry area is pre-letting costs. When preparing your first tax return for your lettings business, you have to sort your costs into those that are preparatory to letting and those that are part of letting. Generally, the costs of getting a property ready for letting will not be allowed, because most of these costs will be classed as capital expenditure or will fail the ‘replacement’ test. For example, you buy a new carpet to replace an unattractive one in a property you have bought to let. But replacing a carpet will only be counted as a replacement once the letting commences, and although you are in fact replacing a carpet, for the purposes of the letting business it counts as an initial purchase. The same rule will apply to all furnishings and furniture you buy. “An item purchased for the first time does not qualify for any relief,” says HMRC.
Many other costs that arise from putting a property right before the first letting commences will be classed as capital expenditure. “HMRC designates certain costs as capital outlay before the business has started and therefore not claimable, and the same things as revenue costs after the letting has started,” says Christopher Springett, partner at Smith & Williamson. For example, any work that needs to be carried out in order to let the property, such as rewiring, are likely to be classed as pre-letting capital expenditure.
And the taxpayer will definitely not take on the cost of putting a property bought in a run-down state into good order. That’s because the price you paid would have reflected the state of the property and the work required. The money you spend getting the property into a decent state will be reflected in the new capital value. “The underlying principle is that the cost of buying a property in good condition is clearly capital expenditure,” says HMRC. “Hence the cost of buying a dilapidated property and putting it in good order is also capital expenditure.”
However, you can claim for the cost of running adverts for tenants and letting agent fees, and for pre-letting gas and electrical safety checks. But work that needs to be carried out as a result of these checks will not be allowed.
Notwithstanding HMRC’s stance on pre-letting work as outlined above, landlords are entitled to claim expenses incurred before the letting business began under the general business rules that allow you to claim for expenditure that was incurred within a period of seven years before the business began. To qualify, the expense must be one that would qualify as a deduction if it had been incurred after the rental business started – that is, it would need to be wholly and exclusively for letting and not capital expenditure.
The rule can be used but with difficulty. “The seven-year rule is of limited use,” says Mr Springett, pointing out that if you previously lived in the property it could be hard to argue that work was carried out wholly and exclusively for the purposes of letting.
Jackie Hall, tax partner at RSM, agrees that most repairs carried out before the first letting begins will be considered capital works that improve the property or of a dual purpose nature, and therefore won’t be allowed. However, there are circumstances where you can claim costs. “If on the day of purchase you could have let the property, then subsequent repairs should be allowed,” she says.
An example would be work that does not improve the property in any way and is not essential for a letting to go ahead, such as fixing loose roof slates or a dripping tap. The tenants will take the property regardless of the need for some slates to be replaced or the sound of a dripping tap. The work is not capital expenditure, qualifies as repairs and is wholly and exclusively for the property lettings business.
Note that if you are managing a letting business with more than one property, costs that you incur leading up to the letting of a second or other properties that are not capital expenditure will be allowed as deductions – unlike those incurred leading up to the first letting. This is because these will occur after the business has started and are not therefore pre-letting costs.
It may all seem perfectly simple, but often it isn’t, as illustrated by the fact that 107 pages of HMRC’s manual on business income is dedicated to defining what counts as capital expenditure, says Ms Hall. She also recommends that landlords read up on some of the many tax cases dealing with this area, including that of Odeon Cinema’s long battle with HMRC over what counted as revenue and capital expenditure.
Mortgage interest relief
Under new mortgage interest relief rules for landlords, relief will be restricted to the basic rate of tax – 20 per cent. So top-rate tax-paying landlords will get back £20 in relief rather than £45 on every £100 spent on interest payments. Note that the relief will be applied as a tax credit rather than the landlord deducting costs from their rental income. The change will happen in phases. In 2017-18, the permitted deduction from rental income will be restricted to 75 per cent of the landlord’s finance costs. The remaining 25 per cent will be given relief at the basic rate of tax, even for 40 per cent and 45 per cent taxpayers. In the following year, 50 per cent of finance costs can be deducted and 50 per cent will be given lower-rate relief, and so on until in 2020-21 all financing costs incurred by a landlord will be given relief at the basic rate.
Cement your case
You need to be fairly sure that your expenses are allowable before attempting to push them through as you risk sparking an investigation, and/or punitive fines if you are found to be in the wrong. However, you are far less likely to face fines if you can support your claim with a strong argument, and can show that you have applied HMRC’s own guidance using the Property Rental Toolkit and the Property Income Manual. It is your responsibility to know and understand the tax rules if you are not using a tax adviser.
What would raise eyebrows at HMRC when you submit a return, says Ms Hall, are returns relating to the first year of a letting business – this is because they may include expenditure that doesn’t qualify – or returns where big repair bills appear after years of steady returns – such a movement in the figures may prompt further checks by HMRC.
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