This article appeared in the Yorkshire Post on Tuesday 28th June, 2005.

G&E Taxing Times - Property Refurbishment

Duncan Meredith G&E Tax Consultant

This week we examine the tax treatment of expenditure on property refurbishment. Duncan Meredith, tax consultant in Garbutt & Elliott's Property Services Group, looks at the issues surrounding this.

In considering the refurbishment of property, I am assuming here that we are looking at a property letting business; if you are buying to develop and sell on, the issues are much simpler, in that all your expenditure will be set against the proceeds on sale and the resulting profit will be taxed as income (not capital gains).

In dictionary terms, refurbish means renovate, which is further defined as repairing to the original condition. This may mean renewing (reconstructing) or replacing a defective part. So, we are talking about repairs. But care has to be taken not to cross the line into improving the property, if a deduction is to be obtained for the expenditure against income from the property.

A number of years ago, the rules for the taxation of rental income were changed. Now, profits are calculated on business principles. The rules for allowing expenditure on repairs, in particular, were revised (and simplified). Now, the principle is that the expenditure must be wholly and exclusively for the purpose of a property business, calculated as if the business were a trade.

Repairs are allowed as they are taken as a cost in the accounts, in accordance with generally accepted accounting practice. This will cover repairs and redecorating, internally and externally (including painting). Also, maintenance of common parts of offices or flats.

Helpfully, the Revenue made a statement about this in June 2002. This gave the following pointers:

• Capital expenditure represents the original cost, additions and improvements, including a porch/extractor fan or even a bathroom cabinet.
• Particular attention is given to refurbishment of newly-acquired properties or between lettings.
• Renewal or replacement of a part is a repair but if this extends to substantially the whole it is capital.
• Replacing a whole kitchen would be a repair, if the new one were of a similar standard, but not if the whole of it were substantially upgraded (e.g. higher quality materials). Additional units or equipment would be capital.
• If the passage of time leads to technical developments (e.g. double glazing widely introduced), replacement with the 'nearest modern equivalent' is accepted as a repair.
• Accounts provisions for repairs are allowed, if incurred and accurately ascertained. Round sum provisions, however, are not allowed, even though stage payments by tenants to match accrued dilapidations are taxed on receipt.

Capital allowances are a way of giving an allowance for the wear and tear of equipment (referred to as 'plant'). It is available to landlords of commercial properties. Residential property attracts either a deduction for the cost of replacing (not the original purchase) or a straight allowance of 10% of the rents. Separately, repairs to the fabric of the residence (including fixtures such as toilets) are allowed.

It is outside the scope of this article to go into capital allowances in detail but they may be very relevant if you are refurbishing commercial property. If you have acquired it second hand, there may be a valuable tax break on the plant acquired with the building, as well.

My May article looked at the recently introduced allowances for flat conversions (over commercial premises). This is a special example of property refurbishment.

The tax treatment of refurbishment expenditure is relevant when considering capital gains tax (CGT) on the sale of properties. Amounts allowed as repairs against rental income are not available as a deduction for CGT, whereas the cost of structural alterations and improvements is.

One special case to note is where a property has been damaged and a capital sum received in compensation. Ordinarily, this receipt would be taxed as a 'disposal' for CGT but, if it is applied to restore the property, the CGT is deferred (by deducting the receipt from the allowable expenditure on a subsequent disposal).

VAT must be considered as well. There are two issues:

• Recovery of VAT paid on costs; and
• Reduced rate of VAT on costs

To recover VAT, you have to be VAT registered (e.g. if disposing of a new commercial property or having 'opted to tax' a commercial property - both are standard rated) or supplying a new residential or charitable-use property (zero rated). More likely, you will be interested in the second situation, where you can claim a reduced rate of VAT on costs.

Repairs and maintenance work is generally standard rated (so you pay 17.5%, even for listed buildings) but some costs of conversions of buildings into residential use can be zero-rated. Others are liable at the reduced rate of 5%, subject to detailed conditions. This is important, because letting of residential property is an exempt activity and no VAT can be reclaimed.

Finally, a mention for the new 100% allowance for capital expenditure on the renovation or conversion of vacant business premises within the specially designated 'Enterprise Areas' throughout the UK. Introduced in the recent Budget, it will apply when approved by the EU. Its effect will be to treat all such expenditure as if it were a repair, wholly deductible, subject to certain conditions. 

Garbutt & Elliott are Chartered Accountants and tax advisers with offices in Leeds (telephone 0113 273 9600) and York (01904 464100). Duncan Meredith can be contacted at the York office, or by email to dmeredith@garbutt-elliott.co.uk.