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Julie Butler looks at pre-letting costs and their tax implications.

Introduction

In the current economic climate, many property owners are forced to let out property. The reason is perhaps because they cannot sell the property at the right price, or it is an elderly person moving into a care home or a second home that must be let out, or perhaps it is an entrepreneur wanting to start a property business.

Whatever the reasons for the pre-letting costs that might be incurred by the property owner, they can achieve tax relief if these costs are structured properly. There are many tax advisers and their clients who do not think this to be the case.

The Property Business

From the tax year 1995/96, rents, whether they arise on just one or a number of properties and regardless of whether they are furnished or not, are treated for UK tax purposes as relating to a single UK property business. The other change at that time is that in accordance with ITTOIA 2005 s 272, those profits are calculated much in the same way as trading profits, and expenses are allowable if they are incurred ‘wholly and exclusively’ for the rental business. This is reiterated in HMRC’s Property Income Manual at PIM1001.

Expenses Incurred Within Seven Years Before Letting

As such, expenses incurred within seven years prior to the commencement of the letting, and in accordance with these rules, should be deductible on the first day of letting – ITTOIA 2005 s 57. So any repairs carried out before the letting starts can still be deducted from the first year’s gross rents (see PIM2505).

Replacement and Repair of an Asset

By applying normal trading rules, a revenue deduction is allowable for the repair of an asset so long as it is not the entirety that is ‘repaired’, but only a part of the asset, as stated by Buckley LJ in of Lurcott v Wakely & Wheeler CA [1911] 1KB 905. Provided that there is no element of improvement then a replacement of these elements should normally be allowable against rents.

HMRC detail their views on replacement at PIM2020, in the final few paragraphs, and actually mention the replacement of a kitchen as an example. HMRC go on to say that where modern items are used (because the item being replaced, through age, may simply no longer be available, or standard construction techniques and materials have simply progressed) so long as it is the nearest modern equivalent to the item replaced that is used, even though it may technically be an improvement, they will still allow it as a revenue item; e.g., a double-glazed unit replacing a single-pane window.

Most repair work involves replacing old defective parts with something new. However, where the work carried out not only simply restores the defective item to what it originally was, but also alters or improves it, then this amounts to expenditure of a capital nature.

When rewiring the electrical circuits, if better materials are used to create greater capacity to enable the whole system to cope with more modern equipment, then the rewiring costs will not be allowed.

When deciding whether the replacement amounts to revenue or capital expenditure, we must look at what is the entirety. This is demonstrated by two decided cases: Bullcroft Main Collieries Ltd v O’Grady [1932] 17 TC 93 and Samuel Jones & Co (Devonvale) Ltd v CIR [1951] 32 TC 513.

Of particular concern is HMRC’s statement in PIM2020 that expenditure is likely to be capital in nature when it relates to ‘a property acquired that wasn’t in a fit state for use in the business until the repairs had been carried out or that couldn’t continue to be let without repairs being made shortly after acquisition’. Given the concern that the work is required in order to achieve the required rental price, that would give rise to a certain expectation of standards of interior décor, all items of expenditure should be examined carefully to ensure they are genuinely revenue in nature and would therefore be deductible.

Financing Refurbishment

For financing the costs of the refurbishment or simply to withdraw funds for the client, this can be achieved by raising a loan against the property. Regardless of the actual purpose of the loan, all the loan interest would be allowable as a deduction against rents on any loan where the loan value is no greater than the value of the property when first let out – see BIM45700, example 2. In addition, this debt would reduce the net Inheritance Tax value of the asset, which may be seen as an additional tax advantage.

There are clearly ways to achieve tax relief on expenses incurred prior to letting out.

The expenditure incurred prior to letting would therefore have to be wholly and exclusively incurred for the purposes of the rental business and not be capital in nature.

It must also be noted that in certain circumstances, property business losses arising from Capital Allowances may be set against general income. This clearly shows a planning point for when this expenditure is incurred.

Action Plan

Prior to any property being let out all the work that needs to be carried out must be considered. All the estimates of cost must be set out and examined regularly on the refurbishment and repair to be carried out so that maximum tax relief is achieved, not just on the expenses but the finance associated therewith. The repair element must be split from the capital expenditure and a thorough tax planning review undertaken.