Sarah Bradford explores the tax reliefs on offer when renovating a buy-to-let property.
Buying a property to renovate and then let out, can be an attractive proposition, particularly where the buyer has the skills to undertake a lot of the work him or herself.
However, while the aim is to increase the value of the property and maximise the rental income, the tax implications should not be overlooked. Some of the tax considerations that may arise when buying a property to do up and let out are explored in the following case study.
Case study: ‘doing up’ a property for letting
Ian has inherited some money, which he wishes to invest in a property. He plans to let the property out to provide him with an additional source of income. As he is a practical sort of chap, with building and DIY skills, he is keen to secure a `doer-upper’ as he believes he will be able to add value to the property and maximise his rental yield by letting out a recently renovated property.
Buying the property
After looking for a suitable property for some months, he finds a two-bed property in a good location in Leeds. The property is about 40 years old. The décor is tired and the property is in need of modernisation. The property had been owned for over 30 years by an elderly lady, who has recently passed away.
Ian purchases the property for £260,000, financed with a £60,000 deposit and a £200,000 buy-to-let mortgage. He spends a further £2,360 on legal fees, survey fees, and the mortgage arrangement fee.
As Ian owns another property, which he lives in as his main residence, he must pay the stamp duty land tax (SDLT) supplement.
The SDLT payable on the purchase is £10,800, calculated as follows:
|£125,000 @ 3%||£3,750|
|£125,000 @ 5%||£6,250|
|£10,000 @ 8%||£800|
The purchase price and cost of buying the property (including the mortgage arrangement fee) is capital expenditure. The total cost (£262,360) is the base cost of the property for capital gains tax (CGT) purposes; this will be deducted in working out any chargeable gain on the eventual sale of the property.
Renovating the property
The property is in need of renovation. When doing the work, Ian needs to distinguish between repair work and enhancement expenditure.
He upgrades the windows and fits a new front door – the total cost of which is £15,000. He also lays a patio in the garden (cost £2,000) and fits a new kitchen (cost £5,000) and a new bathroom (£3,000).
These expenses are all enhancement expenses, undertaken to improve the property. As such, they are capital in nature; a deduction is not permitted against any future rental income. However, the costs can be taken into account for CGT purposes and will be deducted when computing any chargeable gain on the eventual sale.
There are also some repairs that need to be done. He has the roof fixed to replace some missing tiles (cost £700) and has the property painted throughout (cost £3,500).
A distinction is drawn for tax purposes between repairs and improvements – while improvements are capital expenditure, which cannot be deducted in computing profits (but see ‘cash basis’ rules below), repairs are revenue expenditure and deductible against profits. HMRC recognises that some costs will be incurred before the first let, and where these would be deductible had they been incurred while the property was let, they are allowed under the pre-letting expenditure rules, discussed below.
Make sure you keep details of all revenue expenditure incurred prior to the first let, as this may be deductible under the pre-letting expenditure rules.
Preparing to let
Once the structural work is complete, Ian can begin to prepare the property for letting. He purchases curtains and carpets (cost £4,000) and a fridge and washing machine (cost £700).
The tax system gives relief for the replacement of domestic items but not the original purchase, so the costs of kitting out the property to let out are not deductible against profits.
Landlords (other than those who qualify under the furnished holiday lettings rules) are not eligible to claim capital allowances.
The property rental business usually begins when the first letting commences. Ian, in common with many new landlords, has incurred expenditure getting the property ready to let, and also in marketing the property and finding tenants.
HMRC recognises this, and the legislation allows relief for pre-letting expenditure, as long as certain conditions are met. Relief is available for expenses incurred before the first let commenced if the expenditure:
- is incurred within a period of seven years before the date that the rental business started;
- is not otherwise allowable; and
- would have been allowed as a deduction had the expenditure been incurred after the property rental business had started.
This essentially means that the expenditure must have been incurred wholly and exclusively for the purposes of the property rental business, and must be revenue (not capital) in nature.
Where these conditions are met, the pre-letting expenditure is treated as if it were incurred on the first day of letting.
Ian finds a tenant for his property in January 2017, and the property is let from 1 February 2017. The property rental income commences on 1 February 2017.
Tax is charged on the rental profit. This is the total rental income from all properties in the property rental business, less all allowable expenditure. In Ian’s case, there is currently only one property in his property rental business.
Allowable expenses can be deducted from rental income in working out the taxable profit.
Expenses are allowable to the extent that they are incurred wholly and exclusively for the purposes of the property rental business, and are revenue in nature. Expenses that are typically allowable would include insurance, advertising, letting agents’ fees, stationery, cost of phone calls, accountants’ fees, cleaning costs, gardening costs, etc.
Ian took out a mortgage to enable him to purchase the property. Capital repayments are not allowable in computing profits. However, relief is available for interest on Ian’s borrowings.
The property was first let in 2016/17. For that year only, Ian can deduct all the interest costs in computing his profits. From 6 April 2017, the way in which relief for interest costs is given is changing – moving gradually from relief by deduction to relief as a basic rate income tax reduction. In 2017/18, 75% of the interest can be deducted, with relief for the remaining 25% available as an income tax reduction.
Looking ahead, when the time comes to replace domestic items, Ian can claim a deduction for the cost of a replacement of a similar standard. Where the replacement is superior, the deduction is capped at the cost of an equivalent item.
Prior to 6 April 2017, profits of a property rental business were always computed in accordance with generally accepted accounting practice (GAAP). Under legislation contained in the Finance Bill published in September 2017, the cash basis will become the default basis for most landlords for rental income of £150,000 or less. Under the cash basis, which will apply from 6 April 2017, most items of capital expenditure will be deductible in computing profits (with the exceptions of land, cars, and assets that have a useful life or more than 20 years).
Buying a property to do up and let out can be exciting, but it is important to appreciate the tax implications and ensure that all available reliefs are claimed.