Insights

Landlords with rental portfolios can sometimes overlook the opportunity to claim for capital expenditure on their properties. Whilst capital expenses do not have the same immediate tax impact, they are equally important in the long term and can ultimately make a big difference to tax liabilities.

This article explains the difference between capital and income expenses on a buy-to-let property, the tests that are applied by HMRC and when these expenses can be offset against profits.

How are capital and income expenses on a buy-to-let property claimed?

Usually when a property is rented out, expenses that have been incurred wholly and exclusively for the purpose of offering the property to tenants can be reclaimed. If a property is rented with white goods available and these items need replacing, this cost can be claimed on a ‘like for like’ basis. The cost can be deducted from the rental income as an allowable expense and income tax relief in the year of payment can be claimed on the annual self-assessment tax return.

In some cases, it can be advantageous to classify a non-income expense as capital, especially if it was incurred to benefit from likely capital appreciation in the future. This means that when the property is eventually sold, those expenses can be offset against the capital gains (profits) achieved, reducing capital gains tax.  It can be confusing to understand what expenses would be deemed capital and which are income, the examples below illustrate how HMRC would apply this test.

Applying the refurbishment vs replacement test for capital expenses

Any costs that are not straightforward repairs or replacement for existing items but constitute an improvement to the long-term value of the property, are usually capital expenses.

e.g. Mr Peters has a 4-bedroom house that he has been renting and the bathroom needs refurbishing. He decides to create a walk-in shower in addition to replacing the existing shower bath, in order to improve the rental yield. The expenses related to refurbishing the bathroom in terms of purchasing and fitting like for like replacement items – e.g. the bath, tiles, toilet and basin - can be claimed as an income expense in the tax year they are incurred. The additional shower installation is a capital expense and can be reclaimed if Mr Peters sells the property for a capital gain.  If he also decides to convert a small bedroom in the house into an en-suite bathroom, this will also be a capital expense to be claimed at a later date.

Is land and buildings a capital expense?

Capital costs will include the original purchase cost of the land and buildings and any initial improvements to prepare a property for rental. If Mr Peters were to buy a house that needed completely gutting in order to be rented, the cost of this would be a capital expense to be offset against capital gains tax on an eventual sale. They cannot be deducted against the rental profit.

The rule of thumb is that any costs relating to replacing or repairing what was already offered in a property available for rental can be classified as income. Brand new costs incurred are typically capital in nature. For instance, if a house was rented already and the roof needed replacing, this would be classed as income because without a secure roof the property can no longer be rented. If a new property was purchased for the purpose of renting and the roof needed replacing before it could be made available for tenants, this is capital.

Applying the ‘wholly and exclusively’ test to capital expenses on a buy-to-let property

The other important aspect of expenses is the ‘wholly and exclusively’ rule whereby any expenditure must be solely related to the business purpose it was assigned to. For instance, if Mr Peters decides the flooring needs to be refurbished and he wants to replace the existing carpets with wooden flooring, this is more expensive and only the portion that is equivalent to replacement carpet costs can be deducted against rental income.

If the shop offers him a bulk discount and he buys extra flooring to use at his home too, the  total expense only partially meets the wholly and exclusively rules and the portion to be used at Mr Peters’ home needs to be separated from the total cost. His accounts would need to be adjusted to claim for partial tax relief as follows:

Purchase and fitting of original carpet is £35/m2 at total cost of £500

Purchase of wood flooring is £60/m2 at total cost of £1720 (includes £860 for own property)

On his tax return, Mr Peters can only offset £500 against rental income. If the wooden floor can be shown to have added value to the property, the remaining £360 cost can be claimed as a capital expense and offset against the final capital gains tax liability on the eventual property sale. No claim can be made for the additional £860 flooring purchased.

Accounting for ‘dual purpose’ expenses

In this situation, although the expense is only partially allowed, the assets purchased are wholly and exclusively used at / by the property. Where an asset has dual use, known as ‘dual purpose’, the situation can become more complex. For instance, if a car is used partially for the purpose of managing rental properties and then partially personally, the mileage that can be applied to business use needs to be carefully recorded and claimed for. Only the expenses relating to business activities can be offset against income. If the car is used 25% of the time for business and requires repairs, only 25% of the repair cost can need to be classified as an expense according to the percentage of time it is used for.

If you have a rental property and would like advice on the tax payable or how expenses on a buy-to-let property are claimed, please contact partners@rjp.co.uk.