Property development: Converting houses into HMO’s

The process of converting your dwelling house to an HMO varies according to the council in which you live, but there are a few critical points to be aware of when you are converting your existing property into an HMO. Therefore, if you want to learn more about HMO's and convert an existing property into an HMO, and understand how to obtain planning permission, what are the benefits of investing in HMO’s along with their tax treatment, this blog post is for you.

• What is an HMO?
• Whether your property meets the HMO criteria?
• How to convert an existing property into an HMO?
• Benefits of converting your existing property into an HMO
• Tax treatment of HMO’s

What is an HMO?

A house in multiple occupation– commonly referred to as an HMO – is a property that is rented to three or more tenants who are not family members. Several landlords let HMO's because they believe them a more efficient way to manage a rental portfolio. While there may be additional work involved, the prospect of collecting rent from a larger number of tenants and potentially achieving a higher rental yield is appealing. Additionally, certain properties and locations are well-suited to HMO's. For tenants, HMO's are occasionally preferable due to the possibility of lower rent payments and the opportunity to live with more people. It includes –

1. Converted houses into bedsits
2. Houses that have been converted into flats but are not completely self-contained
3. Student residences that are not owned by a university or a public entity
4. Residencies for migrant workers

Also See: Types of Tenancy Agreements for Tenants

Whether your property meets the HMO Criteria?

Determining whether your property meets the HMO criteria can be challenging; just as is the case with many aspects of the town planning industry, there are some grey areas. If you're unsure about the status of your property, the Barnes v Sheffield City Council (1995) 27 HLR 719 court case established a list of nine useful criteria that may help you –

1. The origin of the tenancy – whether residents arrived in a single group or were recruited independently by the landlord;
2. The extent to which facilities were shared;
3. Whether the occupants were responsible for the entire house or just their individual rooms
4. The extent to which residents can and do lock their doors.
5. The responsibility for filling vacancies – whether that of the existing occupants or that of the landlord.
6. The group’s stability.
7. The size establishment.
8. The mode of living - to what extent communal and to what extent independent.

How to convert an existing property into an HMO?

If you're considering converting a property to an HMO, there are a number of steps you'll need to take, from complying with legal requirements to making the property comfortable for more people.

1. The majority of HMO's require an HMO licence. If you rent your property to five or more tenants from different households, the house is at least three stories tall, and the tenants share toilet, bathroom, or kitchen facilities, you will almost certainly require a licence. If you meet any of these criteria, you will almost certainly require a licence, and it is appropriate to check with your local authority. Each HMO will require a separate licence, which will be valid for five years.
2. To comply, you must ensure that an annual gas safety certificate is submitted to the council, as well as that smoke alarms are installed and that safety certificates for electrical appliances are available upon request. Different authorities may add additional criteria, so be prepared to meet additional requirements.

3. You may also require HMO planning permission to make certain changes, depending on the extent of the work required to convert the property. When engaging in any of these activities, please keep a record of all correspondence, applications, and approvals to ensure future coverage.

   Sometimes applications concerning changing the use of a property to an HMO is not always straightforward, as Article 4 Directions are generally in place to maintain a balanced housing stock, and too many HMO's in an area can be problematic, with the following potential issues:

   1. Increased noise complaints
   2. Increased anti-social behaviour
   3. Increased levels of crime
   4. Increased pressures on car parking
   5. Increased pressure upon local services
   6. Loss of local character
   7. Loss of single-family dwelling houses
   8. Dominance of private renting
   9. Reduction in environmental quality
   10. Poor standard of accommodation

Also See: What are the rules around evictions of Tenants?

Benefits of converting your existing property into an HMO

Despite the increased risks and regulatory requirements associated with landlord HMO's, it can be a lucrative investment having the following benefits –

1. Rental yields from HMO’s are typically three times that of standard single-let rentals.
2. HMO's are in demand because single rooms are becoming unaffordable for tenants priced out of the traditional rental market.
3. Collecting rent from multiple tenants separately can result in increased cash flow – if one tenant vacates or fails to pay rent, you will still receive income from the remaining tenants.
4. There may be tax benefits, as there are generally higher costs to offset.
5. As we enter a post-pandemic recession and many peoples incomes are impacted, renting a room in an HMO is a more cost-effective option.

Tax treatment of HMO’s

1. Cash basis

   – The cash basis of accounting is now the default method for the majority of property businesses operated by individuals or partnerships with annual revenue of less than £150,000. Rental income and expenditure are treated as trading income for companies, and the same tax treatment applies to HMO's and multi-let properties.

2. Renovation costs

   – Frequently, most of expenditures on HMO's or multi-let properties can be classified as revenue costs. This means it is deductible as a corporation or as an individual. Generally, capital items that are included in the acquisition cost for capital gains tax purposes are easily identifiable. For example, adding an extension, demolishing walls, or building an annexe.

   Where expenditure is incurred to repair an existing item, even when modern equivalent materials are used, this is considered a revenue cost. Generally, a ‘repair is defined as the general day-to-day work required to maintain the property in order to generate rental income. If a repair exceeds the scope of a simple repair or equivalent replacement, it may be classified as capital expenditure.

3. Capital allowances

   - Unlike the majority of single-let properties, HMO's and multi-let properties could be eligible for Plant and Machinery Capital Allowances. A tax deduction can be claimed on qualifying items located in HMO's and Multi-Lets communal areas. A portion of the expenditure on these communal area assets is treated as a rental business expense.

   Previously, landlords are allowed to claim allowances for kitchens and bathrooms that were converted into shared rooms within a house. However, this opportunity has been effectively closed as a result of HM Revenues recent tax case victory. Where individual rooms do not provide residents with the facilities necessary for daily private domestic existence, HM Revenue considers that shared facilities such as kitchens, bathrooms, and living rooms do not qualify for relief.While this decision eliminates the ability to claim capital allowances on a large number of expenditures, it is still possible to claim for items such as plumbing systems, electrical systems, lighting, and lifts.

   If your HMO conversion is on a small scale, it may not be financially feasible to conduct a comprehensive review. However, significant tax savings may still be realised for larger scale conversions, making the exercise worthwhile. One benefit of claiming capital allowances is that any rental loss on an HMO or multi-let property can be offset against non-property income. This could result in a reasonably large tax refund.

   Also See: Capital Allowance for New Structures and Buildings

4. Combining HMO’s and multi-lets with single let properties

   – Due to the fact that a property rental business is taxed as a single entity, tax losses from current and prior years can be used to reduce the tax bill on HMO rental profits. Therefore, if you are a property investor with significant buy to let losses, these can be offset against profits from an HMO or multi-let property, effectively generating tax-free income.

5. Additional costs

   – Typically, landlords of HMO's include utilities, broadband, and council tax in the rent they charge tenants. All of these expenses must be itemised and reported separately on the investors tax return. However, these additional costs are fully deductible if they are incurred “wholly and exclusively” in connection with the property rental business.

Conclusion

The CGT position for HMO's and Multi-Lets is the same as for single-let dwellings, just as it is for income tax. Although, because properties are frequently extended and renovated, there is usually a significantly higher level of capital expenditure to be deducted. CGT is not an issue because many investors do not wish to sell such an income-generating asset.

If you have any queries or want specialist advice on tax deductions on HMO’s, and want to claim various expenditures to lower your income tax liability as a landlord, kindly call DNS Accountants on 03330886686, you can also e-mail us at enquiry@dnsaccountants.co.uk

Also See: Landlords’ eviction ban phased out – New notice periods from June 2021

Disclaimer :- "This article was correct at the date of publication. It is intended for general purposes only and does not constitute legal or professional advice. Independent professional advice should be sought before proceeding with any transaction".

About the author

Owais Bombaywala
Working closely with individuals and businesses to help grow their business requires a significant amount of experience and industry knowledge. Owais is BA (Hons) Accounting and Finance and Member of ACCA. Besides being a compliance champion, he specialises in Property tax planning. With over 7 years of experience in Accountancy and Tax world, our clients count on us to give them timely and up to date advise to help them make the right move. Owais works closely with some of the DNS’s most valued clients to give them the confidence they need to focus on their business. He is known for his calm nature and proactive approach. At DNS, we proud to be a modern and client centric firm. Our advise doesn’t just look at what’s best for your business moreover our aim is to help you achieve your personal goals. Away from work, he resolve family disputes and provide care and support to elderly people. He is a founding member of Human welfare organisation Hounslow.