Lee Sharpe continues his consideration of the tax implications for adapting a property for designation as a house in multiple occupation (HMO).
Without further ado, continuing the case study from part one of this article series, my very basic analysis of Yasmin’s expenditure on the conversion is set out below:
Suggested indicative analysis from Part 1:
Dwellings and the entirety of the asset: Everything, everywhere, all at once
A key factor in the ‘capital versus revenue’ dilemma is: what is the asset we are repairing or replacing? It is generally agreed that if you replace the entire asset, the expenditure is capital, whereas if you replace part of an asset, that is generally a repair and deductible (unless perhaps the new component amounts to a substantive improvement, in which case we may be back at disallowable capital expenditure). Helpfully, HMRC gave us its view in its Tax Bulletin 59 back in 2002:
“In the case of residential accommodation we accept that the ‘entirety’ will normally be the house or the block of flats that is let.”
Tax Bulletin 59 was reproduced in HMRC’s Property Income Manual at PIM2020 until February 2018, after which HMRC appears to have decided it was no longer needed. This means that when we replace part of a let property (e.g., window, wall, or floor, or a fixture such as a cupboard or integrated appliance), we are likely to be repairing the overall property – unless the new item is substantively superior to the previous item when that was new.
1. Structural work to internal walls: Install extra shower room – even CGT relief is not guaranteed
These are works to the fabric of the building, but not repairs to maintain an asset (or part of an asset).
One would typically assume that the cost of such improvements will be recovered on disposal of the asset – an enhancement under CGT rules. But there are important conditions in TCGA 1992, s 38(1)(b), including that the expenditure:
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must have been incurred in order to enhance the asset; and
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must [still] be reflected in the state or nature of the asset at the time of disposal.
If Yasmin inserted additional walls on a temporary basis to maximise the number of bedrooms but intended to remove them prior to eventual sale as a more traditional residential layout, the walls would not be ‘reflected’ in the asset at the point of disposal, and the cost of building and perhaps even removing them might not be allowable for CGT purposes.
However, it might also be that if the cost of structural work to put the property back into a more conventional format were to enhance the property’s value for onward sale, then Yasmin’s original structural work might not still be ‘reflected’ at the point of disposal (so no CGT relief for those costs) but the reversionary works prior to sale might nevertheless rank as allowable enhancement costs.
2. Replace and expand existing kitchen and main bathroom
Of course, a new kitchen and replacement main bathroom will be better than the ‘old’ kitchen and bathroom, but as noted in part one of this article, that alone does not mean such work is disallowable against rents as capital improvements. What matters is whether the quality of the new kitchen, etc., is superior to the quality of the ‘old’ kitchen when originally installed in the property. Have we (say) moved from a standard kitchen with pre-fabricated units to handmade or solid wood units? If not, the work may simply be a repair. Again, we might expect an inherently ‘better’ new kitchen (or bathroom, etc.) to appreciably increase the value of the property – more than a short-term fillip reflecting where the property is in its maintenance cycle.
However, an HMO is likely to need more units, etc., and these additions will be a capital improvement. Hence, the expenditure has been apportioned (as noted above) to reflect extra cabinets, fridge and storage space fitted in the kitchen and bathroom. I am going to suggest, however, that Yasmin installs the additional facilities on the first floor as a ‘kitchenette’ to serve the upper rooms. Broadly, the rooms on the ground floor benefit from a large kitchen but more modest bathroom facilities, while the opposite applies upstairs.
3. Fire doors, etc.
The new doors are more substantial and officially fire-rated, so they amount to a capital improvement and are not allowable against rents. The expenditure may have been mandatory in order to secure licensed HMO status, but ‘necessary’ does not necessarily mean ‘allowable’.
Capital allowances and residential property
It is unusual to secure capital allowances in residential property; while property letting is a qualifying activity for capital allowances purposes, the relevant legislation (CAA 2001, s 35) specifically prevents a landlord from claiming relief on expenditure incurred ‘for use (by the tenant) in a dwelling-house’. What the legislation actually means is that assets which will be let out for use by the tenant as part of a dwelling are ineligible (so assets used by the landlord in their own dwelling, such as office equipment, remain eligible for relief).
HMRC’s Business Brief 45/10 (in late 2010) warned that HMRC intended, going forward, to treat communal areas (i.e., kitchen, lounge, etc.), as part of a tenant’s dwelling, but that “common parts” such as hallways, stairs, lift, landing and the like in a multi-dwelling property would not be considered part of a tenant’s dwelling (so capital allowances could continue to be claimed therein). Business Brief 45/10 may not have been as generous as Business Brief 66/08, but the changes were logical.
Unfortunately, HMRC has more recently published a version of its Capital Allowances Manual at CA11520, suggesting HMRC has been surprised by taxpayers actually applying that logic to HMOs:
“We are aware that some taxpayers have submitted [Capital Allowances] claims in respect of shared parts of houses in multiple occupation (such as hallways, stairs, landings, attics and basements within the houses). They contend that these shared areas are not part of the dwelling-house and that allowances are therefore available. We disagree with this position.”
HMRC is arguing that an HMO is one ‘dwelling-house’ despite being tailored to separate occupation. Interestingly, while the taxpayer in Tevfik v HMRC [2019] UKFTT 0600 (TC) lost because their records and claim were poorly structured:
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despite initially rejecting the capital expenditure on plant in the common parts of the HMO, HMRC actually relented prior to the hearing; and
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more importantly, the tribunal judge agreed that the common parts of an HMO were not part of a tenant’s dwelling, so they were not excluded from claim by CAA 2001, s 35.
Perhaps in some cases, very little needs to be done to a standard dwelling house to turn it into an HMO. Here, however, significant work has been required in order to accommodate higher-than-normal occupancy, and the special criteria for an HMO licence – with more kitchens and bathrooms than a single household would typically need.
Conclusion
In Part three of this article series, I will look further at capital allowances in the ‘common parts’ of the building; HMRC may take a different view as to deductibility, and careful consideration and disclosure is, of course, recommended.
