The issue of claiming repairs and maintenance as a deductible expense is of major importance because this type of activity is generally the largest cost after interest expenditure when owning a rental property.
Capital improvements are of no immediate or future tax benefit to you as the tax payer because they get "capitalised" and added to the value of the building which is no longer depreciated (following the removal of depreciation on buildings in April 2011). It is effectively "black hole" expenditure.
Where possible you want to treat expenditure as repairs and maintenance so that a full deduction in the year it was incurred can be claimed.
With New Zealand's love affair of property investing it isn't surprising to find that the tax laws on these matters are lengthy, complex and grey.
Below is an overview of some of the aspects involved that we as accountants go through when looking at this type of expenditure. It's by no means a complete analysis and needs to be done in conjunction with an experienced property accountant who knows this part of tax law well.
1. Does the property (or will the property) derive income?
The point here is that the property is or will be available for rent. This is a pivotal step, because if it is not, then no investment expenses can be deducted. Where we often find this step not satisfied is when a tenancy ceases and the owner undertakes work in order to prepare the property for sale. In such a scenario the costs are not deductible as repair and maintenance costs.
2. What is the part of the property that is being worked on?
When it comes to property the "asset" is big - it's the house as a whole unless a particular part of the house is considered a chattel (e.g. water cylinder, stove etc). Common chattels are easy to define and the IRD have a list. However, it is not a definitive list, and outside of this list reference to chattels involves applying the logic and steps from a guidance document provided by the IRD that is 53 pages long!
For property investors, defining the asset as the property is important because the next steps focus on the nature and scale of the work. When you take into consideration the total size and value of the property it is not unusual to find expenditure that you may think would be considered improvements is in fact not.
3. What is the nature and extent of the work done to the property?
This stage assesses whether repairs and maintenance expenditure is deductible, and to do so consideration needs to be given to the nature and extent of the work done. For the sake of simplicity I have whittled it down into the following sub-steps.
3a. The work that has been completed did this result in a reconstruction, replacement or renewal of the asset?
Is the expenditure over and above making good wear and tear or does it have the effect of changing the character of the property? A refresh of the paintwork both inside and out is not changing the character - you undertake such work to maintain the property and therefore this is clearly repairs and maintenance. However, does the removal of the kitchen wall to the lounge to get that open plan feel constitute a change to the character? Arguably not. Knock down an outer wall to add on a new bedroom and the definition of reconstruction, or change in character will have occurred.
Another common undertaking within rental properties is refreshing the kitchen or bathroom space. In the case of the kitchen, this forms part of the building so a refresh to this is not going to result in a substantial change to the whole property. The tiling of the bathroom and reinstall of a shower unit form part of the building and again in isolation are not a substantial change to the whole asset. But complete the bathroom, kitchen bench and kitchen wall at the same time ...... and it is possible you have changed the character or the nature, and the scale of the work done may constitute that it is an improvement. See the next step for further clarification on this.
If the work isn't considered a reconstruction, replacement or renewal of the property, the activities could still be caught under the following step.
3b. Has the work changed the character of the property taking into account:
- the nature of the work done, and
- the scale of the work done
The nature of the work done questions whether the work has gone beyond repairs and has changed the character of the property. Any repair work to a property will result in some degree of improvement. However, for that expenditure not to be deductible as repairs and maintenance the work done must go beyond ordinary restoration and change the character of the asset, such as the case of adding an additional bedroom mentioned in the previous section.
When determining the scale of work done, weighting is placed on the cost of the work although it is noted that this is only one of many factors to consider. Take for example a replacement of the roof. Although this by itself does not change substantially the whole of the property, it is a considerable expense. The deciding factor in this situation is the material used. If the roof is replaced with like for like materials then such expenditure would be considered repairs and maintenance. However, replace the roof with a different product and the "nature", "extent", "renewal", "substantial" aspects are all satisfied and this expenditure would be considered an improvement and therefore capitalised with the building with no right to depreciate that expenditure.
To confuse the matter further, don't be fooled by always thinking that the activities need to be on a large scale to be considered improvements. The guidelines we are given also consider the installation of insulation. The addition of new insulation is considered an improvement because it substantially improves the house as a whole. However, the replacement or top up of existing insulation would meet the definition of repairs and maintenance.
Other factors
• Was the work an accumulation of deferred repairs? Arguably you are not disadvantaged by undertaking the repairs in an accumulated repair job to a property. However, because the nature and scale of the work done can be significant there is always the possibility of it being viewed as improvements and not repairs. Our position would be to err on the side of caution on such a matter and undertake repairs on a more regular, routine basis rather than deferring.
• Did the work done form part of one overall project? If you are undertaking repairs at the same time as making improvements to the property, then it is possible for those repairs to take the character of the improvements and therefore be considered improvements.
If, for example, repairs were undertaken on a completely separate part of the property whilst also undertaking work that is clearly improvements, it is possible to split those costs out and claim them as repairs and maintenance. When considering this factor it is very fact specific and can swing either way. To assist with clearly splitting these types of events it is important to have invoices separately issued for the types of work performed, particularly if you are using the same contractor.
• Was the asset worked on recently acquired? If the property was recently acquired and you undertake repair work on it, such work could be considered to be an improvement. The argument here is that the asset would have been acquired at a discount because of the necessary works and as such the expenditure on repairs increases the value of the property. If you can prove otherwise then it is possible to still claim the costs as repairs and maintenance.
As mentioned above, this is a brief overview of considerations when determining whether costs are repairs and maintenance or improvements. There are many more minor factors and tax cases that are taken into consideration when coming to a final conclusion, please consult a professional to help you.
At GRA many of our clients are property investors which means we devote our attention to these matters to ensure you get the best possible outcome within the parameters allowed. If you don't think your accountant is doing this, then give us a call and arrange a time to meet with us.
Salesh Chand
GRA Business Advisory Director
www.gra.co.nz
Contact Salesh at saleshc@gra.co.nz or call +64 9 522 7955