Capital Gains on Property Sales: Deductibility of Renovation Costs

Sale of a property after renovation work: whether the costs are deductible

The transfer of a property gives rise to a capital gain or loss for the transferor because the change in the composition of the taxpayer’s assets reveals a change in their value, pursuant to Article 33(1) of Law 35/2006 of 28 November on Personal Income Tax and the partial amendment of the Corporate Tax, Non-Resident Income Tax and Wealth Tax Acts (Official State Gazette of 29 November; hereinafter, the PIT Act).

The amount of the capital gain or loss is determined by the difference between the acquisition and transfer values under Article 34. For transfers for consideration, those values are defined in Article 35 as follows:

Acquisition value of the property

“1. The acquisition value consists of the sum of:

(a) The actual amount paid for the acquisition.

(b) The cost of investments and improvements made to the acquired assets, and the expenses and taxes inherent in the acquisition, excluding interest, paid by the purchaser.

Under the conditions laid down in the regulations, this value shall be reduced by the amount of depreciation.”

Transfer value of the property

“2. The transfer value shall be the actual amount for which the disposal took place. The expenses and taxes referred to in point (b) of paragraph 1 shall be deducted from this amount insofar as they were paid by the transferor.

The actual disposal value shall be the amount effectively paid, provided that it is not lower than the normal market value; if it is lower, the market value shall prevail.”

Under this provision, the acquisition value used to calculate the capital gain or loss includes the actual acquisition price, investments and improvements made to the home, and expenses and taxes inherent in the acquisition, excluding interest, where paid by the purchaser.

Expenses and taxes inherent in the acquisition include, among others, notary, Land Registry, conveyancing and legal fees, as well as Transfer Tax or, where applicable, Value Added Tax.

By contrast, repair and maintenance expenses are not included in the acquisition value. Article 13 of the Personal Income Tax Regulations, approved by Royal Decree 439/2007 of 30 March (Official State Gazette of 31 March), refers to these expenses when listing deductible expenses for calculating income from real estate.

What constitutes an improvement?

The Personal Income Tax legislation does not expressly define an improvement. However, paragraph 3 of Rule Two of the Resolution of 1 March 2013 of the Accounting and Auditing Institute, which sets out rules for recording and valuing tangible fixed assets and real estate investments (Official State Gazette of 8 March 2013), defines an “improvement” as a set of activities that changes an item of fixed assets and increases its previous productive efficiency.

Paragraph 3 of Rule Two of that Resolution also defines an extension as a process through which new elements are added to a fixed asset, thereby increasing its productive capacity.

On that basis, repairs and maintenance are those intended to preserve the property’s useful life and productive capacity or usability. Extensions or improvements, by contrast, increase the property’s capacity or habitability, or extend its useful life.

Accordingly, depending on the nature of the work, it may qualify as an improvement or extension—in which case it is included in the acquisition value—or as maintenance or repair expenditure. The cost of replacing the kitchen tiles is an example of the latter and is not included in that calculation.

Since these are questions of fact, the taxpayer must be able to substantiate the various works, when required, by any means of evidence admissible in law, as provided by Article 106 of General Tax Law 58/2003 of 17 December, before the Tax Administration’s management and inspection bodies, which will assess the evidence as appropriate.