If ever there was a grey area for property investors, it’s the question of whether work done to a property constitutes tax-deductible repair work or non-deductible capital expenditure.

There is a general permission in the act that allows a deduction for repair costs where there is a link between the cost incurred and the ongoing generation of assessable rental income.

This general permission is tempered by the capital limitation that says that where works are capital in nature, essentially amounting to improvements or betterment of the property, those works are non-deductible capital costs. This means costs can either be fully tax deductible or non-deductible and non-depreciable if they amount to improvements to the building.

Deductibility tests

Most investors are familiar with the concept that improvements are non-deductible, but the specific tests to determine if an item of expenditure is an improvement are interesting.

They begin with ‘identifying the asset’. For example, in the replacement of a new roof, is the new roof an asset in its own right? Or because the roof is attached to the building and has no context other than when attached to the building, is the replacement roof a repair to the building itself?

If the work is a repair to the building itself, rather than the creation of a new asset, it is far more likely to be considered deductible.

From there, the process involves considering the extent and degree of the works and whether they go beyond basic maintenance and must be considered capital in nature.

This limb of the test was helpful to IRD through the leaky building crisis when repairs often required extensive and expensive reclads that needed consenting under new improved building code. The vast majority of these works were ultimately considered to be capital in nature due principally to the extent and degree arguments.

So, what are some of the lesser- known’ circumstances where building works are non-deductible?

Dilapidation repairs:

These occur when a property is purchased in a run-down state and the new owner immediately undertakes a renovation programme to make the property fit for purpose for letting. Typically, the price paid for the property will reflect the poor state of it and the need for the upgrade so the cost of this work is essentially considered to be part of the cost of buying the property and capital in nature rather than separate tax-deductible repair costs. The fact that the works are needed to secure the tenancy and the rental home are not sufficient to make the costs deductible.

Post-tenancy, pre-sale work:

Where a tenancy is allowed to end and works are then undertaken to renovate the property, and this leads to the property being sold rather than re-let, the costs of this renovation work are not tax deductible. This is because the nexus with taxable rental income does not exist if the works are undertaken after the tenancy ends and the property is not re-let. In essence, the works are designed to maximize the sale price of the property and the non-taxable capital gain on it so there is no deduction available. Many investors feel aggrieved by this given the need for the renovation is generally a result of wear and tear caused by the letting of the property, but that in and of itself is not sufficient to generate a deduction when the works are done after the last tenant leaves.

This then brings into focus the importance of a planned maintenance programme that is ongoing whilst a tenant is in the property. Doing works while the tenancy exists is key to deriving a deduction for maintenance work. It is false economy to put off maintenance and allow a property to deteriorate especially if the works needed to bring it up to saleable standard are then rendered non tax deductible.

Finally, if you are having to undertake costly repair work, keep good evidence to support the expenditure needed, keep the invoices for the works and take some before and after photos of what has been done. Wherever possible make repairs with like-for-like components so that the argument that a property has been improved as a result of the works is diminished.

PFK Withers Tsang & Co specialise in advising on property-related transactions, valuation and restructure services, and tax planning. PKF Withers Tsang & Co Phone 09 376 8860, www.pfkwt.co.nz