Lessons to be learned from the Christchurch Earthquakes
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In light of the Christchurch earthquakes and the ongoing fall out of lost buildings and businesses in the Christchurch CBD, many commercial property investors and business owners are now turning their minds to the properties they own or lease. As discussed in the summer 2010 issue of Tauranga Property Investor Magazine, the Building Act 2004 requires territorial authorities to adopt policies on earthquake prone buildings within the area. This is a huge issue for the Tauranga CBD, as the majority of older two-storey buildings fit in this category. |
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Earthquake prone buildings are defined as those built before 1976 and include all building types except those used wholly or mainly for residential purposes. Residential properties that are included within the definition are those that have two or more stories and contain three or more household units. Earthquake prone buildings must conform to, and exceed, 33% of the current Building Code standards. Buildings built after 1976 are unlikely to be earthquake prone.
If a building is assessed as needing work because it doesn't comply with these benchmark standards, the owner will have 5-10 years to complete structural strengthening work at their own cost.
However, if they are thinking about redeveloping or selling in the near future, this may bring the issue to the forefront.
Q. Can you buy or sell an earthquake prone building?
A. Yes, the new owner will become responsible for the strengthening work. It is recommended that purchasers carry out independent investigations prior to purchasing a property that is likely to be earthquake prone.
Q. I am completing alterations to an earthquake prone building, do I have to strengthen my building at this time?
A. Yes, the strengthening work needs to be completed at the same time as any redevelopment work and will be included as part of the building consent requirements.
Q. Is the cost of completing strengthening work on earthquake prone buildings deductible for tax purposes?
A. Generally speaking, a person is allowed a deduction for expenses to the extent to which they are incurred in deriving assessable income. However, when the expenditure involves significant work on an asset the deductibility test can become muddied. In such cases, a person needs to distinguish repairs and maintenance expenditure (which is deductible revenue expenditure) from capital/replacement/improvement expenditure which is capital in nature (i.e. non deductible).
The capital versus revenue distinction has long been a bane of contention for tax advisors and their clients. There is much case law for advisors to draw on. However, in terms earthquake repair and strengthening costs there are no clear-cut answers. This is because the work is often costly, and remedial work often significantly improves the value of the property.
Determining whether work is a repair (revenue) or a replacement (capital) involves reviewing the following:
- The nature and extent of the work
- The costs relative to the asset value/cost
- The increase in estimated useful life
- Any improvements in function
As a general rule, if work does no more than merely restore the property to its 'as new' condition, it is normally deductible. The one exception to this rule is where the property was purchased at a lower cost with knowledge that a problem existed (what advisors refer to as a dilapidated state). Work that changes the character of the property is indicative of work that could be determined to be of a capital nature. Case law has identified that work that results in a significant improvement to the asset can be a factor that indicates expenditure of a capital nature but is not determinative.
Q. What about the disposal or demolition costs of an irreparable building, are these costs deductible?
A. The government announced that the law will be amended to allow a deduction for the loss arising from a building that has to be destroyed as a result of an event beyond the owners control (i.e. an earthquake). To qualify for the deduction the building has to be irreparable. Please note that any insurance proceeds will be treated as income.
Q. How are insurance payments received for repairs or irreparable damage treated for income tax?
A. The income tax treatment of an insurance payment will depend on the purpose of the insurance policy and how it relates to your business.
Some payments are capital in nature, others paid in respect of lost profits are treated as income. Payments received for irreparable damage caused to a building are treated as a payment as if you sold the property. This could cause issues, as there may be an element of depreciation recovery in respect of the deemed sale of the building which is subject to income tax.
Q. On 28 March 2011 the Government announced tax relief to those affected by the September 2010 and February 2011 earthquakes. What are they and how will they affect me?
A. The government has provided an exemption so businesses do not have to pay tax or GST on trading stock they have donated within four months of either the 4 September or 22 February earthquakes. The government has also exempted donated goods from being subject to gift duty. For example the free gas that was given away at service stations may have attracted gift duty. Certain welfare contributions provided by employers will be tax-free within eight weeks of either earthquake. The IRD will extend statutory tax dates for those affected on a case-by-case basis.
Janine Hellyer is a Director with RHB Chartered Accountants Limited.
Disclaimer
This article is general in nature and should not be treated as professional advice. It is recommended that you consult your advisor. No liability is assumed by RHB Chartered Accountants Ltd for any losses suffered by any person relying directly or indirectly upon the article above.
Published in Tauranga Property Investor Magazine, Winter 2011
