Are my expenses capital or revenue?
One common question asked by investors is whether they are able to claim refurbishment expenditure as revenue expenditure or whether it is capital. Because of the large amount of funds required to invest in property, mixed with the possibility to carry forward losses to offset against future rental profits, it is very important that property investors claim revenue expenses correctly. This article will look to point out the difference between capital and revenue expenditure and help investors make an informed decision about what their expenses should be categorised as. It will also explore some examples of capital expenditure and examples of revenue expenditure.
What is the difference? With regard to property refurbishment capital expenditure are costs which lead to an improvement in the property and thus may lead to an increase in the overall value. Revenue expenditure is costs incurred for the repair or replacement of assets within a property. This is restoring the property to its former condition. Both types of cost have different tax treatment.
The tax treatment of capital expenditure is different from revenue expenditure. Capital expenditure is capitalised meaning it is added to the price of the property and used as a deduction when calculating the value of the capital gain when an investor comes to sell the asset. This is not always ideal for property investors especially those who adopt a buy and hold strategy. This is because it could be many years before the investors come to sell the property meaning that the relative value of the invoice in tomorrow's money will be less and potentially the investor may have lost the receipts! Revenue costs are expensed meaning that an investor can deduct from their rental profits. This means that they are likely to benefit from tax relief in the short term.
Common Mistakes. The biggest mistake that investors make is that assuming costs are capital when they could be claimed as revenue. The reality is that usually the majority of works conducted during a refurbishment will be revenue in nurture, meaning that they should be expensed. Investors will make the mistake of starting with the view that works are leading to an improvement and therefore capital. They will then try to pick out which costs are revenue from their builders invoice. This is often not helped by poor advice from their accountant.
Capital Expenditure Examples. Capital expenditure results in an improvement to the property. The vast majority of most structural works during a refurb will be capital such as knocking down walls, building a new extension or a loft conversion. Another example is the works conducted to bring a worn or dilapidated building up to a lettable standard (more on this later). These capital improvements should be easy to recognise as being capital and as HMRC point out, it is a ‘question of fact’ whether it leads to an improvement or not. Where there is a mixture of capital and revenue expenditure reasonable apportionment is allowed.
Revenue Expenditure Examples. Typical revenue expenses would include repair or replacement of boilers, plastering, painting and decorating, wiring, replacing windows, repairing brickwork etc. In fact the majority of work conducted during refurbs will usually be revenue in nature.
Dilapidated Property. It is mentioned above that HMRC takes the view that works to bring a dilapidated or worn property up to a lettable standard are capital. Here you need to use common sense judgement supported by evidence to back your view that the property was in a lettable standard. Take for example if you are buying the property using mortgage finance. A prerequisite of this will be a survey being conducted which will make an assessment of whether the property is lettable or not. This can be used as evidence to support a claim of revenue expenditure on improvement/replacement works. The survey may point out remedial works required to bring the property to a lettable standard, in which case this will help you to separate out which costs are capital and which are revenue and apportion based on this. You should also ensure that you take photos of the property as proof. Other evidence you use could be invoices from builders (more on this later), and whether the property was let or occupied when you purchased it.
Modern equivalent. It is acceptable that when replacing old single glazing windows or boilers that you will use modern technology with the replacement such as double glazing in the case of windows. Therefore do not fret that you have to capitalise these items, they will be allowable as revenue.
Invoices and record keeping. It is important that your invoices from contractors support your claims in terms of terminology. For example it could be advisable to have our builder provide separate invoices for works which are capital and those which are revenue where there is both types of cost. Also ensure that revenue expenditure is worded correctly with terminology such as replace and renew. Finally make sure you keep records of your invoices, ideally in a digital format, which will be required when you come to complete your tax return. In the case of capital expenditure it might be 20 years plus before you need to use them so ensure your record keeping system is robust. Ensure you also keep other items that support the claim such as surveyor reports and photos.
Conclusion. A typical property investor will spend a significant amount of funds over the course of their investing career on refurbishments. It is likely that these refurbishments will be large enough that they lead to losses, particularly in the early years. These losses can then be carried forward to offset against future rental profits. It is therefore critical that you correctly claim revenue expenditure during these refurbishments. Remember that the majority of costs will normally be revenue and to keep a robust record keeping system to support your claims.
If you need help with working out which are capital and revenue costs then we offer a number of different packages that suit sole trader investors and those looking to invest through a limited company. If you would like to discuss different structures and what might be most suitable for you then please get in touch with us.
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