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When computing the profits of a property rental business, the landlord can deduct business expenses provided that those expenses are incurred wholly and exclusively for the purposes of the business. However, no deduction is given for items that are of a capital nature.
All properties need on-going maintenance to some degree. A distinction is drawn between repairs and improvements. A repair is a revenue expense for which a deduction will normally be given in computing profits whereas money spent on improvements is capital expenditure, for which no deduction is given. Although in many cases it will be clear whether the expenditure relates to a repair or to an improvement, in some cases the boundaries can become blurred, as expenditure incurred in repairing a property may also improve the property. This is often the case in relation to older properties where repairing the property with new material may also enhance it.
HMRC take `repair’ to mean the restoration of an asset by replacing subsidiary parts of the asset and by way of illustration give the example replacing tiles on a roof that were blown off by a storm. By contrast, there will be a capital improvement rather than a repair if, say, the roof is removed and an additional storey added. Expenditure that takes the asset beyond its original condition is generally regarded as a capital improvement rather than a revenue repair.
Other common examples of repairs for which a deduction would be given include:
The fact that a repair might be significant and involve considerable financial outlay does not prevent it from being revenue in nature and turn it into a capital item. The test remains whether the expenditure is incurred in restoring the property to its original condition (revenue) or enhancing it (capital). Refurbishing a kitchen, for example, would be regarded as a repair (and thus a deductible expense) provided that the replacement kitchen is of a similar standard to the original. However, the expenditure is treated as being of a capital nature if the kitchen is substantially upgraded.
That said, HMRC treat the replacement with a `modern equivalent’ as a repair rather than an improvement, even if the replacement also improves the property. An example of this would be replacing old windows with double glazed windows. Likewise, a repair of an old asset using modern material materials is generally permitted as a deduction provided the new material is broadly equivalent to the old, such as replacing a wooden beam with a steel girder, even if doing so provides a measure of improvement.
Problems can also arise when a property is purchased in a dilapidated state and done up before being let out. Again, it may not be clear where the dividing line between revenue and capital expenditure falls. Whilst incurring costs on a property immediately after acquisition does not in itself make that expenditure capital in nature, in the same way that the cost of purchasing the land and building is capital expenditure, any costs incurred in putting a dilapidated property in good order are also capital expenditure. Similarly, alterations to a property that amount to a reconstruction or improvement of the property, such as building an extension, are also capital in nature.
As illustrated above, the dividing line between repairs and improvements, and consequently between deductible revenue expenditure and non-deductible capital expenditure, is not always clear cut. When in doubt, the landlord needs to apply the `like for like’ test. If the replacement is equivalent to what was there before, there is a good chance that HMRC will accept that it is a repair. However, if the replacement is significantly better than the original, it is more likely to be regarded as an improvement and the deduction denied.
Sometimes timing is everything.
This article is from Tax Insider, monthly UK tax magazine. First issue FREE Click here to join!