In his third article in the series, Lee Sharpe looks at what happens when a novice landlord takes on a typical second-hand property.
In the first couple of case studies, we looked at scenarios involving seasoned landlords who were developing their own properties from scratch, and the possible implications of changing your mind partway through a development project.
In this case study, I will be considering a scenario when a budding landlord/landlady takes on their first property at the outset of their property investment activity.
Case Study 3: New property business
Shahab is a young professional who is looking to move into property investment as a stable source of investment income. He secures a buy-to-let (BTL) mortgage facility of up to £150,000 and selects a suitable property, worth around £180,000. The property survey/report reveals the following:
- the property has a couple of windows that need replacing and one that Shahab wants to add, for £1,500;
- the roof needs some repair work, valued at £2,000;
- there is some damp in the property, and a new damp proof course (DPC) costs £1,500; and
- the boiler is old and needs replacing, at a cost of £2,500.
Also, Shahab wants to:
- extend into the roof space to add a bedroom at a cost of £20,000. This will make the property much more marketable, and significantly add value on eventual resale;
- install an intercom/security system, costing £1,000. The property has no alarm system. Shahab reckons that the property will appeal to a young professional couple, who may well both be at work during the day, so a decent security system will offer peace of mind;
- decorate and re-carpet throughout, before letting the property, at a cost of £2,500; and
- fit a new kitchen, at a cost of £4,000.
Pre-letting expenditure
There are rules about costs incurred before the letting commences but they do not generally turn a deductible cost into capital expenditure. The basic conditions are that pre-letting expenditure can be claimed from day one that the letting actually commences, provided that it has been incurred within the seven years prior to commencement, and would have been allowable if the business had already been ongoing at the time the cost was incurred.
This will be Shahab’s first property and he has not received any rental income yet. HMRC guidance states that the property business starts when it is first let out (it could be said that it actually starts when Shahab is in a position to first let out and so markets it, but that is likely to be a fine point of little relevance in most cases). Shahab may end up with several properties, but that business commences only once, for tax purposes. He may not be able to claim any relief until this property is ready to let, but prima facie, there is up to £35,000 to claim.
The projected expenditure here is £35,000, on top of buying the property in the first place. This represents roughly 20% of the cost of the property. Capital costs cannot be claimed against rental income but must be ‘stored’ to be used for capital gains tax purposes when there is a disposal. So how much of Shahab’s expenditure is capital?
Repair or capital improvement?
Some guiding principles:
- If you are physically adding something to the property that wasn’t there before, such as an additional bedroom in the roofspace, or a security system, then it is likely capital.
- If you are significantly enhancing the value of the property (such as a new bedroom, etc.), then it is likely capital.
- If you are making a tangible improvement to the property or part of it, then it is likely capital. So (for example) if Shahab’s kitchen is of a better quality, or the windows or boiler, then they may be capital (but see below).
- Putting a property back into a good state of repair is not an improvement unless perhaps it was significantly discounted on acquisition for being in a poor state of repair in the first place. While Shahab’s first property did need some repairs, the purchase price was not significantly discounted when compared to similar properties in the region, on the basis that the general state of repair was broadly as one might expect given the age of the property, and fell within what one might consider as the normal maintenance cycle for residences of that nature.
- Using superior products or practices (the ‘modern-day standard’) will not generally be considered an improvement where the intention is to repair or replace; the improvement is an indirect consequence of maintenance or ‘making good’. We typically see this in the context of energy-efficient boilers and windows.
Conclusion
Here, Shahab has amassed expenditure of £13,000 that may be claimed against rental income at the point the letting business actually starts. It is easy to be dissuaded from making such a large claim on day one of the business, for fear that it might result in rental losses (including for tax purposes) for a year or more. But that does not change the character of the expenditure.
While there will typically be only one rental business commencement, a similar analysis exercise may be required every time that Shahab adopts a new (or newly-acquired) property for his rental business; it is just that he will not have to wait until that property is in a position to be let, to claim the repair costs. A final point about modern techniques and materials is that we shall soon be transitioning from boilers to other methods of heating houses. For example, it may not be long before air source heat pumps become the ‘norm’, despite their cost.
