Leaky Buildings & LAQCs
Leaky Building Repair Costs – Deductibility?
Q. It has cost thousands to repair my leaky rental property - is it deductible?
A. With the number of leaky homes in New Zealand, and the cost of repairing them escalating, we see more questions about this subject every year. Unfortunately the answer is “It Depends”
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 of leaky home repair 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. So when a person incurs expenditure recladding the property in a different material as a permanent solution to prevent water access is this a significant improvement?
A. To provide a somewhat ‘grey’ answer to this question, we draw on the fact that you are able to use the ‘materials of the day’ to return the asset to its original condition.
The issue that arises in respect of leaky buildings is that you are not going to replace the defective cladding systems with exactly the same materials restoring it to its original state.
Under current law you are not able to return the asset to its ‘as new’ condition using the original defective cladding system. New and improved systems have been developed and the costs of recladding the property using a different cladding system is likely to improve the asset in terms of being less susceptible to repairs.
In using the ‘materials of the day’ argument, as long as you are returning the asset to its original condition, an arguable position is that such expenditure is deductible.
Conversely if the work involves substantially replacing or reconstructing the building, (i.e. pushing out walls or replacing cladding with significantly higher specification cladding) that expenditure is likely to be capital in nature.
What Now for the LAQC Structure?
In the May Budget 2010, the Government announced that from the start of the 2012 income year (1 April 2011 in most cases) an LAQC will no longer be able to attribute losses to its shareholders.
Existing LAQCs will have a number of options:1. Elect to become a “Look Through Company” (LTC)
An LTC is essentially a partnership for tax purposes but remains a company for commercial purposes. The LTC is similar to an LAQC whereby losses are attributed to the shareholders, subject to rather complex loss limitation rules. However, an LTC requires that income is also attributed to shareholders.
The intention behind the change in tax law is to prevent the taxation of the profits at company level rather than an individual's marginal tax rates. In the past, under the old LAQC regime, individuals have been able to utilise the losses to offset against other income, but not had to return the income in their own name at higher tax rates once the company started to make a profit.
Existing QCs and LAQCs will not automatically become LTCs. Instead, they will have to elect into the regime, and they must do so within 6 months of balance date (September 2011 in most cases) for the losses to be attributed to shareholders from the start of the 2012 income year.
Whilst the final legislation allows a two year period for decision making there are complex rules about attribution of losses and the timing of the transition to an LTC where adverse tax consequences may arise.
2. Transition into a Limited Partnership (LP), Partnership or Sole Trader
Existing QCs/LAQCs will be able to elect to transfer to one of the above listed entities without any further tax cost, if it is done so within six months from the start of the 2012 income year. The existing LAQC will be liquidated.
This gives you a few months to consider which entity is appropriate for you.
If you decide to wait to restructure, there will be additional tax costs associated with disposal of assets and on existing reserves if electing to become an LTC outside the transitional provisions timeframe.
3. Do nothing
If existing QCs and LAQCs do nothing, they are able to stay in the QC regime but with no ability to attribute losses to shareholders. Losses will still carry forward in the company and are able to be utilised to offset against future income.
The time to review your personal tax position is now.
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 Property Investor Magazine, Autumn 2011
