Understanding capital expenditure made by landlords

If you have purchased an investment property and are planning to rent it out, you might be wondering whether you can offset some of the costs relating to repairs or other expenditure incurred prior to letting.

Revenue expenses are allowable against rental income; if you are buying a property in very poor condition and renovating it for rental use, most of the costs would be capital expenses which will not typically qualify for immediate relief. Instead, they may qualify for capital gains tax relief, if the property is sold in the future.

This article explains the rules around revenue and capital expenditure for landlords, with an outline of what is allowable against rental income and what isn’t. It also includes some practical examples to help you navigate this area of property taxation.

What’s the difference between capital expenditure and revenue expenses?

The key distinction between the two usually comes down to whether you are:

• Repairing or maintaining – restoring an asset to its original condition (revenue expense); or
• Improving or enhancing – making the asset better than it originally was and probably increasing the value (capital expenditure).

What counts as capital expenditure for landlords?

Firstly, as we highlighted already, capital expenditure costs are not treated in the same way as revenue expenses. These cannot be claimed against rental income but can be offset against capital gains tax if the property is sold. The claim is made by adding the cost of each expense to the property’s original cost (adjusted purchase price) when calculating capital gains on sale.

Examples of allowable capital expenditure for landlords

Capital expenditure for landlords could include the following:

• Property costs – e.g. the actual cost of the property, legal fees related to the purchase, surveyor costs, stamp duty.
• Property improvement costs – e.g. extensions, conversions, structural additions to the property, building upgrades like new central heating, kitchen and bathroom upgrades, exterior landscaping.

Note that initial purchases of furniture and fittings are not allowable as a tax-deductible expense but replacement of existing items is allowed.

Other property expenses that can be claimed

There are some other categories of revenue expenses that landlords can potentially claim. These are pre-letting repair costs, incurred before the first rental receipt is received. Allowable costs will include travel expenses, phone bills, agent fees, marketing the property and decorating work. These can be deducted from rental income once letting commences and included within the tax return for the relevant tax year.

What is allowable as a pre-letting expense?

There are strict rules governing what is allowed within the pre-letting expenses rules, as follows:

Expenses must have been incurred within seven years before the date the rental business starts;
Expenditure cannot be used to offset tax due against any other income or capital gains;
Expenses which would be tax deductible if costs were incurred after the rental business started.

Pre-letting expenses are treated as if they were incurred on the same day that the rental business started and are deducted from the profits together with all the other letting expenses incurred during the same tax year.

Can loan interest on pre-letting expenses be claimed?

The rules concerning interest paid on loans taken out specifically to fund pre-letting expenses follow the same rules as mortgage interest on buy-to-let properties. Since April 2020, private landlords with personally owned property can no longer deduct mortgage interest from their rental income. Instead, it is possible to claim a tax credit of 20% of the mortgage interest payments. The exception is when the property is owned through a company and current rules allow for loan interest to be offset as a tax deductible business expense (effectively getting relief at 25%).

If you have borrowed money to fund allowable pre-letting expenses, any interest on this borrowing would be subject to the same 20% tax credit system.

Pre-letting expenses for repairs and maintenance

One of the most common questions relating to the issue of pre-letting expenses relates to costs incurred for the repair and maintenance of a property which will be coming onto the rental market. It may be possible to offset costs against income as a revenue expense subject to certain conditions being met:

The cost relates to replacing worn or dilapidated items;
The property was already in good enough condition to be rented out before repairs were conducted;
The property price was not significantly lower due to the repairs and maintenance needed prior to letting;
If the price was reduced, it was only based on the cost of rectifying ‘normal wear and tear’.

If you are concerned about whether pre-letting costs you have incurred will be allowable for income tax purposes, we recommend taking photos before and after the works so you can demonstrate the extent of works needed. More details about the documentation you should keep for a possible tax claim is included below.

Worked Examples – Capital and revenue expenditure for property

Example 1: Kitchen Renovation

Mr. Smith purchases a rental property for £250,000. The kitchen is old but functional. He spends £15,000 replacing the kitchen with a similar standard kitchen.

If the existing kitchen was worn out and Mr. Smith replaced it with a similar standard kitchen, this would be a repair (revenue expense) and allowable against rental income.

If the kitchen was upgraded and enlarged, involving structural work and with high-end appliances and luxury fittings (beyond like-for-like replacement), this would be regarded as a property improvement (capital expenditure) and not deductible against rental income. This expenditure can be offset if and when the property is sold to reduce capital gains tax.

Example 2: Property requiring complete refurbishment

Mrs. Jones buys a property for £180,000 that needs significant work before it can be let. She spends:

£5,000 on repairing existing bathroom (fixing leaks, replacing broken tiles)
£20,000 on a new kitchen where the old one was completely unusable
£10,000 on rewiring the property
£8,000 on decorating throughout
£15,000 on building a small extension

Some of these costs can be allowed as revenue expenses and some are a capital expense. For example:

Revenue expenses

£5,000 bathroom repair is allowable against rental income as a revenue expense
£8,000 re-decorating is likely allowable against rental income as a repair

Capital expenses

£20,000 kitchen is likely capital expenditure if the old one was beyond repair as it is an upgrade (Potentially some of the cost could be classed as a revenue expense)
£15,000 extension is capital expenditure

Grey areas for tax

£10,000 rewiring could be capital if a complete system replacement was needed, or revenue if the existing system could be improved

Example 3: Property boundary dispute costs

Mr. Brown purchases a rental property and later discovers a boundary dispute with a neighbour. He spends £7,500 on legal fees to resolve the dispute and establish clear boundary lines.

These legal fees would be capital expenditure as they relate to establishing property rights and would be added to the property’s cost basis for capital gains tax purposes if and when it is sold.

What documentation is required for capital expenditure claims?

It is always important to keep clear and accurate records showing every expense incurred. This relates to for both capital expenditure and revenue expenses; HMRC may ask to review your records.

We recommend you keep the following records:

• Original receipts and invoices which include details of all work completed;
• Ask builders and suppliers to separate costs on their invoices;
• Keep copies of contracts for larger projects with details of all the costs and project requirements;
• Retain planning permission or building regulations approvals and the costs;
• Keep documents of any financial agreements with contractors or architects.

You may need to show bank statements for the period of works, including details of any payments made to contractors, suppliers, consultants.

It is also advisable to have some photographic evidence showing what the property was like before and after.

If you have rental property and would like some help with property tax, please email partners@rjp.co.uk.