Property rental in the UK and expense accounting

In July 2023, Ania bought an apartment with the intention of generating rental income. The property was in poor condition, so the new owner paid a significant amount for renovation work. She also undertook a reconstruction of the premises, which involved creating an additional room.

As soon as the renovation began, Ania hired an agency to oversee the work and place rental advertisements.

After bringing the property to a rentable condition, Ania applied for a rental license. She received it in September 2023 and immediately rented out the apartment, intending to record the incurred expenses as deductible costs.

However, she learned that she could only claim tax relief for expenses incurred after commencing business operations, so she came to our office for advice.

Accounting for rental income using cash basis

According to regulations introduced in April 2017, individuals earning rental income from property not exceeding £150,000 annually are required to use the cash basis.

However, the owner has a choice – they can account for a given tax year using the accrual basis.

Cash basis vs. accrual basis

What is the difference between these two accounting methods? Cash basis is a method where transactions are recorded on the date money is actually received or paid out. Accounting on an accrual basis allows transactions to be recorded on the date an invoice is issued or a bill is received, rather than when money actually changes hands.

Accounting pre-trading expenses

According to HMRC's interpretation, business activity begins when the rental starts, i.e., on the date the first lease agreement is signed. Applying this interpretation, Ania would not be able to deduct any costs incurred for preparing the property for rent, as she only signed the first agreement in September 2023, by which time all preparatory work had already been completed.

So, how should expenses incurred for this work be classified? According to HMRC guidelines, these are preparatory rental expenses (pre-trading expenses) and do not fall within the scope of rental business activity.

Does this mean they cannot be deducted? Fortunately, no – the rule is that they are considered to have been incurred on the date the business commenced and should be accounted for as such. It doesn't matter whether the accounting method is cash basis or accrual basis.

Pre-trading expenses are considered to have been incurred on the date the business commenced, even if the expense was actually incurred before that date.

This rule can be applied provided that the expenses would have qualified as business operating costs incurred after the rental business commenced.

What constitutes a business operating cost, and what is a capital expenditure?

In connection with preparing the apartment for rent, Ania incurred three types of expenses:

• for the reconstruction of the premises; 
• for the renovation of the premises;
• for agency administrative services.

Will all these expenses be eligible to be classified as pre-trading expenses and included in the costs of running a rental business? No.

The renovation of the property increased its value, and therefore the costs of this renovation should be classified as a capital expenditure, not deductible as a business expense.

The cost of renovating the property is a capital expenditure, not a business expense.

However, it may be allowed as a deduction when calculating capital gains or losses in the future, if the property is eventually sold.

However, expenses incurred for renovation and property management agency services can be deducted from profit using the rules regarding pre-trading expenses.

However, it's important to remember that if there was any private use of the property before or after starting the rental business, the tax deduction must be proportionally reduced by that private use.