Assumptions and Scope
Assumptions have been made. Whilst many allowances, reliefs, etc., apply outside of the following assumptions, please do take care as always to ensure that they are relevant to your own circumstances.
We’re assuming the perspective of a property investment/rental business owned by an individual(s), is appropriate. It is quite different for property developers, Trust or corporate ownership and VAT, and are beyond the articles’ scope. The emphasis is on residential properties, as averse to commercial. We’re also assuming the Construction Industry Scheme doesn’t apply; this should be the case for non-developers, although if some tax inspectors are to be believed, no one is safe!
The articles will cover:
1. Property tax fundamentals – why and when does the capital / revenue divide matter?
2. The capital / revenue divide – when is it capital, and when is it revenue?
3. Tax treatment of capital expenditure – all is not lost!
Property Tax Fundamentals: What is the Capital / Revenue Divide and Why is it Important?
The capital / revenue divide is basically the difference between whether something is subject to CGT or Income Tax: if it’s capital then it’s CGT; if it’s revenue then it counts towards Income Tax. We could equally call it the ‘capital/income divide’, although it is traditionally referred to as capital / revenue.
Why is it Important?
There are two reasons why ‘Capital v Revenue’ is important:
1. You can’t set capital costs against your income, so the ‘benefit’ of your capital costs – buying the property, improvement costs, etc. – is postponed until you make a gain on the property, usually when you sell it. Where costs can be set against income, they’ll be of immediate benefit. Treating costs as expenses against income usually means getting the tax benefit much more quickly.
2. CGT rates are less than the corresponding Income Tax rates: this tax year, if you pay Income Tax of 20%, then you’ll normally pay CGT of 18%; if you pay Income Tax at 40% or 50%, then CGT is at 28%. So CGT is ‘better’ than Income Tax. But when it comes to your costs, remember that an extra £100 deductible against Income Tax will save up to £50 in tax, whilst the most it will save against CGT is £28.
So, if the costs can be set against income instead of capital, you’ll get relief more quickly, and probably pay less tax overall.
Property Life Cycle and Tax
The ‘life cycle’ of a typical property investment business is broadly as follows:
1. Acquire the property; probably renovate, etc., for the rental market, and advertise for tenants. Usually, there are some very significant up-front costs to setting up in the property business.
2. Having obtained a tenant, there is now an income stream. There will be ongoing costs – repairs and finance costs; perhaps legal and professional costs such as arranging tenancy agreements, marketing for replacement tenants, accountancy fees, etc. There may be extensions or other improvements to the property to increase the property’s rental yield or marketability during this phase.
3. The final stage is the sale of the property. There may again be repairs, or costs of conversion – such as back to one family house from several studio apartments – and costs to market for sale, plus legal expenses.
Of course we’re looking at one property here. There may be several properties in a portfolio, each at their own separate point in the ‘life-cycle’.
How is Each Stage Taxed?
The two principal taxes involved are Income Tax and Capital Gains Tax (CGT). Broadly speaking, Income Tax is charged on an ongoing commercial activity, whilst CGT arises when the underlying assets are disposed of.
Some might argue that CGT doesn’t apply to an ongoing property business. This is generally true, although there may be costs in the income phase which affect CGT, but I think it makes sense to look at the business as a whole, and to have an awareness of the tax implications for selling individual properties, or the entire business.
Phase 1 - Buying the Property
There is no immediate tax relief: the purchase cost, including stamp duty, legal fees, etc., is a capital cost, to be set off against the proceeds of the eventual disposal of that property – for CGT. Likewise expenditure on property improvements. But they may not actually be ‘improvements’ – more on this later.
Phase 2 – Running the Property Business
The income from renting property is subject to Income Tax. The costs of running that property – agents’ fees, repairs, insurance, etc., are ‘revenue costs’, and are all deductible therefrom, and the net amount is taxable. The income is ‘matched’ against the costs incurred to generate it.
Some costs incurred before letting commences may also be deducted from the income once it has started. But – as in Phase 1 above – improvements during this phase are capital, and set to one side. The profits and/or losses from all properties let on a commercial basis (broadly so as to make a normal profit) are pooled together and the net income is taxed.
Phase 3 – Selling the Property
Once the property business has ceased, the property is (presumably) sold. The sale is subject to CGT: the deferred capital costs of acquisition / improvement incurred before, during or after the property was let are added together, and the total deducted from the sale proceeds – themselves net of selling costs, such as solicitors’ and agents’ fees.
Let’s take a simple example of a person buying a single property business to illustrate the advantages of revenue costs over capital costs. John, who pays Income Tax at 40%, buys a single rental property for £200,000; he gets £1,000 per month in rental income after agents’ fees, insurance and the like.
He spends £8,000 on new windows in Year 1, and £10,000 on a new kitchen in Year 2. He sells at the end of Year 2, for £230,000. What difference does it make if the windows and kitchen are ‘revenue costs’ – repairs, or capital improvements?
Obviously it makes sense where possible to ensure that expenses are deductible as revenue expenses. Both of the above expenditure items have been specifically chosen as they can be either revenue or capital, depending on the circumstances. Don’t assume that just because it’s a large amount, it must be capital. And if it is capital expenditure, make sure that you keep a ‘permanent’ record of it, so it isn’t overlooked when you come to sell!
The following articles will look at the factors which determine if expenditure is capital or revenue, how to optimise expenditure so that it may be treated as revenue cost and, if it has to be capital, where it may still be possible to claim relief against Income Tax.