One of the most recurring issues regarding taxation in real estate sales is the potential inclusion of renovation expenses to reduce taxes, whether the client is a fiscal resident in Spain (IRPF) or a non-resident (IRNR).

In Mallorca, there is a high turnover of properties that are bought, renovated, and sold within a short period, often achieving significant capital gains, which are obviously due to the effort and investment in renovation works that considerably increase the value of the property.

However, tax rules are often contrary to logic, and it catches clients' attention when we point out that most of the renovation works cannot be considered as a "higher acquisition cost" of the property, which would reduce their tax bill.

In this article, we will analyze the current tax criteria and assess the actions that must be taken (before and during the works) to ensure that these are considered as a higher acquisition cost of the property.

How is capital gain calculated?

Both in IRPF and IRNR, the capital gain derived from the sale of a property is calculated by subtracting the "acquisition cost" (i.e., purchase price plus associated expenses) from the "transmission value" (sale price minus expenses associated with the sale).

Among the expenses associated with the purchase, which are considered a higher cost, we have taxes (VAT+AJD / ITP), notarial and registration expenses, mortgage formalization expenses (appraisal, opening commission, etc.), as well as legal and real estate agent fees.

As for the expenses of the sale, they are practically the same, although we can include regularization costs (declarations of new work, registry actions), mortgage cancellation expenses, technical fees (habitation certificate, energy efficiency certificate) as well as legal and real estate agent fees.

Once we know the "transmission value" and the "acquisition cost", it will be enough to subtract one from the other to obtain the taxable base on which the tax will be applied, at a fixed rate of 19% for non-residents and a scale of 19% to 28% for fiscal residents.

Types of expenses: "investments and improvements" vs. "repair and conservation"

The regulations establish the same calculation criteria for IRPF and IRNR, as the law regulating the latter tax expressly refers to the IRPF Law.

Thus, article 35.1.b) of the IRPF Law considers as a higher acquisition cost "The cost of investments and improvements made on the acquired assets and the expenses and taxes inherent to the acquisition, excluding interests, that have been paid by the acquirer".

On the other hand, the same IRPF Law, but in a totally different article (which indicates the deductible expenses in income derived from real estate leasing), introduces the concept of repair and conservation expenses, stating that they are:

• "Those carried out regularly with the purpose of maintaining the normal use of the material goods, such as painting, plastering, or repair of installations.

• The replacement of elements, such as heating systems, elevators, security doors, or others."

Two types of expenses should be distinguished: "investments and improvements", which are those that incorporate novelties to the property; and "repair and conservation", which are those that maintain the operating state of the property.

Therefore, for the purposes of calculating the capital gain in IRPF or IRNR, the AEAT considers that "repair and conservation" expenses are different from "investment and improvement" expenses, and that, while the former are deductible in real estate capital income, only the latter constitute a higher acquisition cost for the purpose of reducing capital gains.

Moreover, both concepts being legally undetermined, the AEAT, in an extensive interpretation of a norm that should not be applicable to individuals, refers to different resolutions of the Institute of Accounting and Audit of Accounts, which considers that extensions or improvements "should be understood as investments that result in an increase in the useful life or habitability of the property", excessively limiting the concept of investment or improvement.

It is noteworthy that resolutions from an accounting institute are used to interpret a concept applicable to individuals who have no obligation to apply such norms, as they are not subject to accounting criteria.

As stated by the TEAC in a resolution of September 25, 2023, "we can advance that with repair and conservation expenses, an asset is maintained in good operating conditions, preserving its productive capacity thanks to repair interventions of existing elements, which do not require replacement or replacing an existing element that, not being susceptible to repair or being obsolete, requires replacement by a new one, maintaining its purpose." That is, any element that does not imply a functional novelty in the dwelling will be understood as repair and conservation.

Only those expenses that involve the introduction of new elements in the property can be considered a higher acquisition cost, but not all those that replace existing materials, even if the new ones represent a clear improvement over the previous state.

On the other hand, "expansion and improvement", according to the same resolution, would be "the implementation of a previously non existing or carrying out structural interventions of such magnitude that they entail an extension of the useful life or a substantial increase in its productive efficacy." Applied to real estate, these would include expansion, rehabilitation (understood as a broad structural intervention in line with what is foreseen in the VAT Law) or the incorporation of previously non-existent installations.

For a more pedagogical approach, we can present the following examples:

Investments and improvements

• Installation of heating, air conditioning, elevators, etc., where they did not exist before.

• Extension works.

• Structural rehabilitation works.

• Energy efficiency improvement works, duly proven.

Repair and conservation

• Replacement of the electrical panel.

• Replacement of windows.

• Replacement of pipes.

• Tiling and flooring of bathrooms and kitchens.

• Replacement of worn parquet.

• Repainting expenses, removal of popcorn ceilings, etc.

• Replacement of heating, air conditioning, elevators, security doors, etc.

• Complete remodeling of bathrooms and kitchens.

• Reorganization of interior spaces without increasing habitable surface.

In any case, the burden of proof lies with the taxpayer, so it must be accredited, in each case, not only the amount of the expense, but also that such expense has effectively constituted an investment or improvement as indicated, providing, in each case, the appropriate evidence, such as: licenses, technical project, detailed and itemized invoices showing the individualized cost of each intervention, documentary evidence of the non-existence of previous installations, previous and subsequent efficiency certificates, accrediting the improvement, etc.

Do not hesitate to contact us for any queries.