The interaction of VAT & Income Tax
The combination of VAT and Income Tax can make a very significant impact on your rental profits. It is rare for expenditure to attract maximum Income Tax Relief and minimal VAT, but important to understand how they interact.
The general rule is that short term ‘net of tax’ costs are lower if expenditure is properly categorised as being ‘repairs/refurbishments’ related rather than ‘capital’ related. That rule is illustrated by comparing examples a-e below (NB. similar principles apply to a company):
Most capital costs are not eligible for Income tax relief, but different VAT rates can complicate any appraisal. For example, on a cost of £20k + VAT you might get:
a) £20,000 capital expenditure which is zero rated (zero rating is most common on new build residential property). In this case, there is no VAT, but there is no Income Tax relief either, so your net expenditure = £20,000.
b) £20,000 capital expenditure which is 5% rated (the 5% rate most commonly applies when work results in a change in the number of dwellings – e.g, when a house is converted into 3 flats). In this case, VAT increases costs by £1000, and there is no Income Tax relief, so net expenditure = £21,000
c) £20,000 capital expenditure which is standard rated (e.g, a new extension). In this case, VAT increases your costs by £4000, and there is no Income Tax relief, so net expenditure = £24,000
Repairs & Refurbishment expenditure
Repairs & Refurbishment costs are almost always allowable for Income Tax purposes, but it is very unlikely that they will also qualify for the zero or 5% VAT rates. So, whilst the examples once again assume a cost of £20k + VAT, this time the Income Tax rate is the variable, giving us the following comparison:
d) £20,000 repairs expenditure at standard rate 20% VAT will add £4,000 to your costs, but if your Income Tax rate is 20% you will receive 20% tax relief on £24,000 and your net expenditure =£19,200
e) £20,000 repairs expenditure at standard rate 20% VAT. VAT increases costs by £4,000, but if your Income Tax rate is 40% you will receive 40% tax relief on £24,000 and your net expenditure =£14,400
In summary, the biggest difference in all 5 examples, is the difference between examples c. & e., with e. being 40% cheaper, than c.
It is therefore essential that you:
i) Take into account the interaction of taxes when considering where best to spend your money (e.g, extension or change number of dwellings?).
ii) Analyse and categorise your expenditure very carefully, and obtain good evidence to support that analysis. This may involve explaining the rules to your builders so that they charge you the correct amount of VAT in the first place!
The above analysis does not account for the fact that if you subsequently sell a let property that you have incurred capital expenditure on, you will eventually get Capital Gains Tax relief on the expenditure. Capital Gains are currently taxed at 18% or 28% on residential property (depending on your marginal rate of Income Tax on disposal), so that should ultimately reduce the costs in a-c by 18 or 28%. For example, the ultimate costs of example c. could be reduced to £17,280, which is lower than any of the other examples, with the exception of e. The only trouble is that you might have to wait for many years to get the benefit!
If you would like to discuss any of the above issues in more detail please give us a call.
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