Lee Sharpe looks at one of the key tax issues when maintaining or improving rental property.
This article looks at the distinction between capital improvements and repairs, and why it is important.
Capital expenditure is incurred broadly when the result is a permanent or long-lasting enhancement to an asset, or its outright replacement. Adding an extra bedroom or extending into the loft would be capital expenditure.
Repairs or ‘revenue’ expenditure is what is incurred merely to preserve or maintain an asset. Painting or decorating would normally be considered to be on revenue account – basically repairs (although painting or otherwise decorating one’s new loft extension would be considered part of the capital cost of that extension, rather than a repair).
Why does it matter?
(a) When you get your relief
One generally gets tax relief for capital expenditure only when the asset (i.e. the property) is sold, under capital gains tax (CGT). If the property is not sold for many years, tax relief can be a long time coming. Repairs, on the other hand, can be claimed in the year of expenditure – effectively immediately.
(b) Rate of tax relief
Income tax costs as much as 45% (for additional rate taxpayers) while CGT costs 28% at most; it is a maximum of 28% for residential property; that falls to 20% for commercial property. But this, in turn, means that the maximum relief for capital expenditure will be only 28% (or 20% for commercial property).
(c) Inflationary effects
Given that property tends to be a relatively long-term investment, one should keep in mind that saving £10,000 ‘in today’s money’ is worth more than saving £10,000 in 20 years’ time.
To put it another way, if I spend £10,000 on a loft extension today, that deduction will be ‘worth’ less when I claim it in 2039 when the property is sold because £10,000 will be worth less in 2039 (or worthless, depending on the degree of pessimism!). It is hugely unfair that people pay CGT on the artificial profit attributable to inflation, but that is probably an article for another day.
Example: Capital or revenue costs?
Jean (a higher rate taxpayer) buys a new property and decides that, although it could be let, it could do with re-plastering and repainting throughout, at a cost of £20,000. These are repairs to the property, and Jean can claim them against her rental profits of £75,000. As Jean’s taxable profits will be reduced from £75,000 to £55,000, This will save Jean £20,000 @ 40% = £8,000 in 2018/19.
Gene buys a new property and decides that he needs to upgrade the kitchen to appeal to a more discerning tenant. Old units are replaced with decidedly more upmarket items. This is an improvement cost and Gene cannot claim tax relief until the property is sold, in 2039. Assuming tax rates stay the same as they are now, Gene will reduce his capital gain by £20,000; assuming Gene already pays income tax at 40%, this cost will reduce his 2039 CGT bill by £20,000 @ 28% = £5,600 (or £4,000 if the property counts as being non-residential – not a dwelling).
So, for the same outlay, Gene will have to wait 20 years to make a smaller tax saving – which is then worth even less, thanks to the effects of inflation. Hence taxpayers tend to prefer if an expense can be categorised as being a repair or ‘revenue expense’ as distinct from capital outlay.
What is the asset?
One of the key issues to consider with ‘capital vs revenue’ is: what is the asset that is being worked on?
If I replace an old laptop, I have replaced an asset in its entirety, and it is inherently a capital expense. Likewise, a car, a factory or a plot of land. It doesn’t matter if I replace the old laptop for exactly the same model or for a newer model that is substantively superior; they both count as capital costs.
If I replace the graphics card in a laptop, most people would agree that I am simply maintaining my laptop. If, however, the graphics card is notably superior to the one it replaced, my expenditure has effectively improved the laptop and it becomes a capital cost.
In terms of residential property, if I do work on something that is attached to the property, the asset I am working on is the entire property. So, replacing the kitchen with something of similar quality will be a repair cost, just like replacing the roof or re-plastering. But upgrading the kitchen with units and appliances of superior quality to the originals would count as improving the property overall, so would be a capital cost.
The replacement of an asset (in a dwelling) that is not attached to the property – such as a sofa, fridge or washing machine – would typically fall under the replacement of domestic items relief regime, such that the overall cost of replacing the item is allowable on revenue account against profits.
The rules are quite a bit different for commercial properties. For example, kitchen units, air conditioning and other fixtures would normally be considered discrete assets in their own right and corresponding expenditure would be considered capital (but potentially qualifying for capital allowances).
Is it an improvement?
This is a quite complex area of the rules, but broadly:
• an item is capital where it enhances the value of the overall asset – usually the property itself. Replacing an old kitchen could arguably increase a property’s value but it will not do so for the long-term, as it will need replacing again in a few years. However, adding an extra bedroom should enhance property value indefinitely, so is a capital expense; and
• where something is ‘better’ because it uses modern materials or construction techniques it is not automatically an improvement. The classic example is replacing single-glazed windows with double-glazed units, since the latter is now ‘the norm’.
Cash basis for property income
Readers who are familiar with the principles of the cash basis for landlords, which commenced on 6 April 2017, might think that the old distinction between capital and revenue no longer applies. Certainly, in theory, the cash basis is a more straightforward regime and does not distinguish between expenditure and revenue expenditure.
Unfortunately, the theoretical benefit of the cash basis is severely restricted when it comes to capital expenditure because it does not apply to certain categories thereof – notably, to:
• the provision, alteration or disposal of land or property, (except, broadly, where it comprises a fixture that might qualify for capital allowances – predominantly for commercial properties); or
• the provision, alteration or disposal of an asset used in a dwelling, except where replacement of domestic items relief may apply; or
• cars, which remain in the capital allowances regime.
The overall effect of the cash basis is that it is not a simplification because the landlord still has to be able to identify capital expenditure, in order to decide if it should be excluded from the cash basis in the first place; furthermore, the landlord will basically get no more tax relief under the cash basis than the traditional approach.
Despite the new cash basis for landlords, the distinction between repairs and improvements remains, and has significant implications for the timing and extent of tax relief. Landlords should not be dissuaded from claiming items as repairs just because they are substantial but should take advice from a suitably qualified professional before spending significant sums, to ensure that they are adopting the right approach for tax purposes.