The basic principle involved in calculating tax-deductible expenses on property is covered by s.272 Income Tax (Trading and Other Income) Act 2005 - expenses are allowable in exactly the same way as for a trade, that is, only if they are incurred ‘wholly and exclusively’ for the rental business. This principle cuts across the board - whether you are a sole trader, partnership or LLP - and also interacts with specific reliefs such as Replacement of Domestic Items Relief and Mortgage Interest Relief. The rules for limited companies (who will be paying Corporation Tax) follow the same principle.
When does the business start?
Generally, a property rental business will be deemed to start when the first property is let (and not before). However, once the business has started, then all subsequent activities (whether related to the initial properties or to properties acquired later) will be treated as part of one and the same business as long as the properties are in the same ownership and located in the UK. (Properties outside the UK would be treated as a separate business).
There are also separate rules for serviced accommodation, which can usually (subject to meeting the rules) be treated as a separate business.
For income tax purposes, the property owner is treated as receiving the profits of a trade (even if the property rental business does not fulfil the HMRC definition of a trade). So, since all the properties are assets of the same business, the allowable expenses relating to any one or more properties can be set against the income from the whole property rental business.
What about expenses incurred before the business starts?
Allowable expenditure incurred before the rental business begins (i.e. the date of the first letting) qualifies for relief under the general rules for pre-trading expenditure, so can be deducted in the tax computation. In order to qualify the expenditure must be
- incurred wholly and exclusively for the purposes of the rental business
- not capital expenditure
- incurred within a period of seven years before the date the rental business is started
- not otherwise allowable as a deduction for tax purposes
- have been allowed as a deduction if it had been incurred after the rental business started.
Qualifying pre-letting expenditure is treated as incurred on the day on which the taxpayer first carries on their rental business, so can be deducted from the first year’s gross rents.
Capital or Revenue?
Expenditure is only deductible from income for tax purposes if it is what is classed as ‘in the nature of revenue’. Broadly speaking, this excludes any expenditure which results in a ‘capital improvement’. Some expenses that fall into this category include:
- The initial cost of the property
- Expenditure which adds to or improves the land or property, such as converting a disused barn to a home
- The cost of refurbishing or repairing a property bought in a derelict or run-down state
- Expenditure on demolishing a derelict building to clear space for a new building
- Expenditure on carparking or an access road
- The cost of buying a new area of land for use with a property that is let
It can however sometimes be difficult to assess whether work in capital in nature or not. This tends to be a matter of fact and degree - an improvement may be so small that it may be counted as revenue expenditure in the absence of any other factors suggesting that it is capital improvement.
Repair of a building using modern materials may suggest that this is a capital improvement, but if the new materials are broadly similar to the previous ones e.g. replacing lead pipes with copper or plastic ones, then this will normally be classed as revenue expenditure. Similarly, replacements due to advancements in technology, such as replacing single glazing with double glazing, are generally treated as an allowable repair, where the functionality and character is broadly the same.
However where a significant improvement arises from the change of materials, the whole of the cost is capital expenditure. This includes things like redecoration after the main work has been done (even though redecoration would ordinarily be a revenue expense).
Although you can’t set the cost of capital improvements against income, you are of course entitled to relief in form of enhancement expenditure allowed against any capital gain ultimately made on sale or other disposal (as long as the improvement is still present on disposal). But since this could be a long way off so it makes sense to look at revenue expenditure wherever possible.
Is the expenditure necessary?
There is a trap here! Just because expenditure is necessary, it doesn’t make it automatically allowable as an immediate property business expense. Where something needs to be fitted to a higher standard in order to be legal, specifically for letting, the implication is that it is an improvement on the original, and therefore a capital expense that cannot be claimed immediately. This often occurs where properties are to be used as HMOs
For example, you buy a flat where the kitchen and bathroom fittings are ‘tired’ and the whole flat needs redecorating. The expenditure will be allowable against the income because the property was clearly habitable before the work was done and the work would not significantly improve the underlying capital value of the property. Of course, the new kitchen and bathroom fittings are likely to be up-to-date and in that sense much better but as long as they are to a similar standard to the fittings they replaced when those previous fittings were new then they will not count as ‘capital improvements’.
On the other hand, if you buy a large HMO and a recently-imposed licencing regime requires it to meet various conditions before it can be let, then it is likely that some of the work will not be classed as revenue expenditure. For example:
- additional fire safety features (as opposed to simply replacing what is there)
- fire alarms and security measures to a higher standard
- additional bathroom and kitchen fittings
- electrical rewiring where this goes beyond simply replacing and upgrading to modern standards
You can of course claim as deductible expenses any part of the work which is just replacing (even if this involves up-grading to the modern equivalent). Any work which is a capital improvement and any making good to the property as a result cannot be set against income. The trick is to judge where the dividing line is between upgrading and improving!
Wholly and exclusively
If a property is let at less than the full commercial rent, any expenditure relating to that property will normally fail the ‘wholly and exclusively’ test. Although, strictly, no expenditure on such properties is admissible as an expense of the rental business, expenses can be deducted up to the amount of rent derived from that property.
Where revenue expenses are incurred partly for the business and partly for private use, any part of the expense that is identifiable as being for business use claimed (there are various rules relating to this).
Obviously it’s important to keep all receipts and other records of expenditure, but this is particularly the case where these are for capital expenditure - as it may be some time before you need these for the purpose of calculating your capital gain on disposal.