A dilapidations payment from an outgoing tenant is taxed according to what it compensates for and what the landlord then does with the money. Where the landlord spends it on repairs, HMRC’s guidance treats it as an income receipt matched by deductible repair costs; where the works are never carried out, it is normally a capital sum derived from the building and falls into Capital Gains Tax. Either way it is outside the scope of VAT.

What is a dilapidations payment?

Most commercial leases, and some residential ones, oblige the tenant to keep the premises in repair and hand them back in the condition they were in at the start. HMRC’s Business Income Manual at BIM43251 describes dilapidations as works of repair or reinstatement for which a lessee is liable where the lease makes the tenant responsible both for repairs and for delivering up the property in its original state.

At the end of the lease the landlord’s surveyor usually serves a schedule of dilapidations. The tenant can do the works, but it is common for the parties to settle with a cash sum instead. BIM43265 calls this a composition payment: a payment to get out of the obligation to make good. In England and Wales, section 18(1) of the Landlord and Tenant Act 1927 caps the damages for breach of a repairing covenant at the fall in value of the landlord’s reversion, and bars damages altogether where the premises are to be pulled down or altered so that the repairs would be valueless.

The tenant’s side of the transaction, including when a provision is needed and how the payment is relieved, is covered in dilapidations provisions for leased premises. This page deals with the landlord who receives the money.

Is the payment rental income?

It is not rent, but that does not settle the question. A property business brings in rents and other receipts from exploiting property (PIM1051), and compensation is classified by what it replaces. HMRC’s Business Income Manual at BIM40115 sets out the principles the courts have applied: a payment for permanent damage to a fixed capital asset is capital, a payment for temporary interference with income is revenue, and a single settlement may need to be broken down into its parts. Those trading principles carry over to property businesses because property profits are computed on trading rules (PIM1103).

Two pieces of HMRC guidance point the way for repairs. PIM1058 lists contributions to expenditure on the repair of a let property among receipts likely to be taxable as income. BIM40130 says that where compensation reimburses deductible expenses, those expenses are treated as reduced by the reimbursement. Either way, to the extent the money pays for revenue repairs, receipt and cost cancel out.

The same thinking applies on a residential let. PIM1052 says deposits that are not refunded at the end of a tenancy are included as income at that point, so a deduction from a deposit for damage is a receipt of the property business.

How is it taxed if the landlord carries out the repairs?

Repairs that put a worn or dilapidated asset back into its previous condition are usually deductible revenue expenditure (PIM2030), and PIM2030 specifically describes a tenant’s end of lease payment for overdue repairs as part of the normal cost of keeping property in repair. So when the landlord spends the settlement on that kind of work:

  • the part of the settlement that funds the repairs is brought into the property business as income, or deducted from the repair cost, under PIM1058 and BIM40130;
  • the repair costs are deducted in the normal way, so only any difference between the two is taxed;
  • any element of the settlement that compensates for rent lost while the works are done is an income receipt on BIM40115 principles, because it replaces income.

If the works go beyond repair, for example replacing old fittings with something materially better, the improvement element is capital and not deductible. The dividing line is explained in repairs or improvements on a rental property. There is no double charge on the part taxed as income: section 37 of the Taxation of Chargeable Gains Act 1992 excludes from a capital gains computation any amount brought into account for income tax, and HMRC confirms at CG12980 that such a receipt cannot also be a capital sum.

What if the repairs are never done?

Landlords often keep the money and leave the building as it is, perhaps because a new tenant will refit it or a sale is planned. The payment then reimburses no expense. Section 22(1)(a) of the Taxation of Chargeable Gains Act 1992 treats a capital sum received as compensation for damage or injury to an asset, or for its depreciation, as a disposal of that asset even though the payer acquires nothing. Under section 22(2) the disposal happens when the sum is received.

Because the landlord still owns the building, the deemed disposal is a part disposal. CG12945 explains that the part disposal formula in section 42 is used to decide how much of the original cost can be set against the payment, with the rest of the cost carried forward to the eventual sale. The gain is then taxed at the normal Capital Gains Tax rates, or within corporation tax if the landlord is a company.

Can a section 23 claim defer the gain?

Often it can. Section 23 lets the owner claim that a compensation receipt is not treated as a disposal, and instead deduct it from the base cost of the asset. HMRC’s conditions at CG15701 are that the asset has not been lost or destroyed and that one of the following applies:

  1. the whole capital sum is applied in restoring the asset;
  2. all of it is applied except a part not reasonably required that is small compared with the total; or
  3. the capital sum itself is small compared with the value of the asset.

CG15703 treats small as 5% or less of the sum (for the second test) or of the asset’s value (for the third), and HMRC also accepts a receipt of £3,000 or less as small whatever the percentage. The third test is the one landlords tend to overlook. A dilapidations settlement is frequently a small fraction of the value of the building, so a claim can turn an immediate gain into a reduced base cost, even when nothing is spent. Where the unspent part is not small, CG15710 explains that a partial claim under section 23(3) still lets the amount spent on restoration be deducted from cost, with only the unspent amount treated as a part disposal.

CG15700 says the claim must be in writing, identifying the claimant, the asset, the compensation and how the conditions are met. The time limit is four years from the end of the tax year for individuals, and four years from the end of the accounting period for companies.

Is VAT due on a dilapidations payment?

No. Paragraph 10.12 of VAT Notice 742 says a dilapidations payment is a claim for damages for the tenant’s want of repair, is not consideration for a supply and is outside the scope of VAT. HMRC’s VAT Supply and Consideration Manual at VATSC05910 confirms that, despite later case law on compensation payments, its policy remains that these payments are normally outside the scope.

Recovering VAT on the works the landlord then commissions depends on how the building will be used. Paragraph 10.13 says input tax is wholly recoverable if the refurbished building is used only for taxable supplies, wholly irrecoverable if used only for exempt supplies, and residual where it is used for both. A landlord who has made an option to tax and relets to a business tenant will usually recover the VAT; a landlord letting the building exempt will not.

How might this look in practice?

Illustration only. A landlord who holds a shop unit as an investment agrees a settlement of £40,000 with a departing tenant: £30,000 for the repairs schedule and £10,000 for two months of rent lost while the works are done. The unit is worth £600,000. The landlord spends £22,000 on repairs, decides the remaining items are not worth doing and relets.

Element Amount Treatment
Loss of rent £10,000 Property income
Repairs carried out £22,000 Income receipt, matched by £22,000 of deductible repairs
Repairs not carried out £8,000 Capital sum under section 22(1)(a)

The £8,000 is about 1.3% of the value of the unit, so it is small under the third test. With a section 23 claim it is deducted from the base cost of the unit rather than taxed now. Without a claim, it would be a part disposal with the cost apportioned under section 42.

What mistakes come up?

  • Treating the whole settlement as tax free compensation, or as capital, without splitting it between repairs, lost rent and any reimbursed fees.
  • Deducting the repair costs while leaving the matching receipt out of the accounts, which gives relief twice.
  • Charging VAT on the settlement, or assuming the VAT on the works is recoverable when the building is let exempt.
  • Reporting a capital gain on unspent money without considering a section 23 claim, or missing the four year time limit for making one.
  • Assuming the landlord’s treatment mirrors the tenant’s: the tenant’s deduction under BIM43265 does not depend on the works being done, but the landlord’s position does.

HMRC’s guidance on landlords’ dilapidations receipts is spread across several manuals, so keep a note of how the settlement was analysed. Surrender settlements raise further points for the tenant, covered in surrendering a lease.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.