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When is building expenditure tax deductible?

One of the key tax considerations encompassing the cost of building work is the distinction between what is capital expenditure and what is revenue. Up until 2012, classifying expenditure on a building as capital meant that tax depreciation could be claimed, compared to revenue expenditure where a tax deduction for the full amount could be claimed when incurred.

However, the removal of the ability to claim tax depreciation deductions for buildings from the 2012 income year now means no deduction is available in most circumstances where building expenditure is treated as capital.

This makes identifying the distinction between capital and revenue expenditure more vital for property owners and Inland Revenue. In most cases the difference is clear, but the boundary between the two is full of traps that can be difficult to avoid.

For this reason, the courts have been asked many times to determine whether certain types of expenditure are capital or revenue. Given the wide variety of facts that have been considered, some of those decisions are not consistent and the distinction remains somewhat murky.

We have had a number of clients seeking advice about the tax treatment of earthquake strengthening costs and we expect this will become a hotter topic in the near future. The tax deductibility of work carried out to remedy “leaky buildings” also remains an issue. In both cases, there is no simple answer and the position depends on the facts of each case.

Earthquake strengthening
Following on from the Christchurch earthquakes, there has been much greater focus on the earthquake rating of commercial property. Strengthening costs can be significant and the issue of whether they are capital or revenue is a key concern.

A number of property commentators are already advising building owners to “future proof” their buildings by increasing the strengthening beyond the minimum requirement of 33% of New Building Standard which in an increasing number of cases is less than what tenants are willing to accept.

A recent Inland Revenue Interpretation Statement outlines (by reference to case law) that work undertaken to strengthen a building, whether or not earthquake damaged, is considered to be an improvement to the building and capital in nature. IRD considers this is likely to be the case even when the work is required by law, such as to comply with council consents. The focus is on the work undertaken, and if the work is seen to improve the asset it will be deemed to be of a capital nature.

The huge scale of this seismic strengthening issue has been identified by policymakers and there has been a call by some to change the law to enable a tax deduction to be claimed for earthquake strengthening costs, so watch this space.

In the meantime, as a general comment, it may be helpful if any work is clearly separated between expenditure incurred in building restoration (non deductible), or from other work that would ordinarily be classified as repairs and maintenance (deductible). Discuss any work that might be undertaken with your tax adviser before expenditure is incurred so appropriate advice can be provided.

Leaky Buildings
There may be a reasonably arguable position for the tax deductibility of expenditure incurred to repair a leaky building provided the property owner was unaware of the water tightness issues and did not pay a lower price because of it.

Part of the concern of the IRD is where a taxpayer buys property at a reduced cost with the knowledge there is a leaky building issue and the likelihood that major expenditure will be required to remedy the issue. In those cases, the IRD would be more likely to assert that the costs of bringing the building up to an acceptable state are capital because the work significantly increases the value of the asset.

A reasonably arguable position (subject to the individual facts of the case) for expenditure undertaken on leaky buildings may be supported if the following are met:

  • The property was acquired with the expectation that it would be entirely suitable to derive assessable income for many years and the price paid reflected this.
  • The repair work will not improve the property beyond what it originally appeared to be, and the character of the property will not be changed.
  • It was always the taxpayer’s intention to derive assessable income from the property.

However, given the complex issues arising from expenditure of this nature on both leaky and seismically compromised buildings, it is recommended specific tax advice is sought before any tax filing position is taken

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