Count on It

With Gavin Goodjohn Staples Rodway

RENTAL EXPENDITURE

Income from renting out a property is taxable in the hands of the owner of the property. However, as with other types of business income, expenditure that is necessarily incurred in the earning of that rental income is deductible for taxation purposes.

This includes obvious expenditure such as rates, insurance and repairs, as well as other expenditure such as interest, depreciation and travel expenses. Generally the three highest expenditure items are interest, depreciation and repairs & maintenance. The purpose of this article is to have a closer look at these three, and some of the issues relating to their calculation and deductibility. It will also look at changes which are currently at the Bill stage in Parliament and are likely to be passed next year.

Depreciation

Depreciation is not a direct expense as such. It is the allocation of the cost of an asset over the economic life of that asset. When you buy a rental property, the cost of that property is not an expense that you claim in the first year of purchase. The reason for this is because you have purchased an asset which will produce income over a long period of time, it is not used up in one year. Therefore, depreciation is the process of allocating the cost of that asset over its useful economic life. Depreciation rates are set by Inland Revenue, and various assets have different rates.

When dealing with property, it is important to note that depreciation is not calculated on land. It is only calculated on the portion of the purchase price that relates to the dwelling, improvements and chattels. Your chartered accountant will generally use a registered valuation or the government valuation as the basis for splitting the purchase price between land, buildings and chattels. It should be noted that chattels have a higher rate of depreciation than buildings, so should be itemised separately where possible. It is recommended that you check with your chartered accountant about the split that is generally acceptable to the Inland Revenue Department, as some valuers have been providing unrealistic figures. It does assist if the component cost is detailed in the sale and purchase agreement, and is therefore agreed between the vendor and the purchaser.

Currently there is a perception in Government that some long term assets eg buildings are being depreciated at rates which are too high and that some shorter term assets eg domestic appliances are being depreciated at rates that are too low. This year's budget highlighted these issues and a Bill has been drafted to address the issue. If the Bill is passed, then using the above examples the depreciation rate for buildings purchased after the date the Bill comes into effect would fall from 4% (diminishing value rate) to 3% (diminishing value rate). The depreciation rate for domestic appliances purchased after the Bill comes into effect would rise from 31.2% (diminishing value rate) to 36% (diminishing value rate) . Diminishing value is the cost of the asset less amounts previously depreciated.

When an asset that has been depreciated is sold, some or all of the depreciation that has been claimed in prior years can be recovered and become taxable income. This happens if the sale value that is attributed to that item is higher than the written down book value. The best way to illustrate this is by way of an example.

Say Mr A owns a rental property, and the cost that was attributed to the dwelling was $80,000. He holds the property for a number of years and the depreciation claimed on the dwelling over that time comes to $20,000. The written down book value is now $60,000. He then sells the property and the sale value attributed to the dwelling is $70,000. He has effectively recovered depreciation claimed of $10,000 which becomes taxable income to him. (Sale value of $70,000 minus book value of $60,000).

When dealing with property in areas such as Tauranga and Mount Maunganui where house prices are generally rising, depreciation is frequently recovered when selling rental properties. It is something that property owners should be aware of, and provide for when realising properties.

Depreciation may also be recovered if there is a change of use of an asset. For example if Mr A had decided that the rental house will now be his family home and moves in, that asset has had a change of use, and will be treated much the same as if it has been sold at market value. So Mr A may have tax to pay on depreciation recovered, but without receiving sale proceeds for the house. Again, this is something you should be aware of and provide for if planning on moving in to a house you have previously tenanted.

Your chartered accountant can advise you on these issues.

The possibility of depreciation recovered is something you should consider when deciding on ownership structures for rental properties, particularly for those people on higher incomes. Depreciation recovered can be a significant amount if the property has been held for some time, and with a tiered rate tax system for individuals, adding depreciation recovered to your other income may push you into a higher tax bracket.

You can also elect not to depreciate assets. This may be particularly relevant if a property is only to be rented short term, and you do not wish to have the situation of depreciation recovered when you move back in to the property. You will forgo the expense claim in the period that the property is rented, but will not have the problem at the end. This election must be made in the first year.

Interest

In order to claim interest as a deductible expense against rental income, it is important that the debt relates to the purchase of that property or to funds spent on that property. It is not the security used for the loan that is relevant, it is what the money was used for.

A common trap is for a couple to buy their first home, live in it for a number of years and either completely repay or substantially reduce the mortgage. They decide it is time to buy a bigger family home, and that their existing home would make a good rental property. They borrow to buy their new house, believing that the interest on the loan will be deductible. Unfortunately they are wrong. The new loan is used for the purchase of their family home, and therefore the interest is not deductible. People in this situation should consult their chartered accountant prior to purchasing their new family home. They can provide advice on how to restructure ownership to overcome this.

Repairs and Maintenance The costs of any repairs and maintenance undertaken on a rental property are deductible in the year they occur. For example replacing a broken shower head, plastering and painting a crack in a wall or redecorating a property to return it to the state it was in when first made available for renting.

There are some circumstances when the costs can not be deducted as repairs expense. For example buying a rundown property and then spending considerable amounts of money on substantial improvements or alteration prior to the property being rented out, the costs should be capitalised and depreciated as explained above. Similarly work carried out which substantially improves a property will also have to be capitalised and depreciated. For example taking down a badly deteriorated wall and putting up a conservatory in its place.

In order to reduce compliance costs, there is an allowance where an item is purchased that has features of an asset, but cost less that $200. The cost of this purchase can be written off in full as an expense in the year of purchase rather than depreciated over a number of years. For example a property owner purchases a lawnmower for $190. It is likely this asset will last for longer than one year, but the cost of the asset can be claimed in full as an expense.

A change which may occur if the tax Bill is passed next year is to increase the level at which assets are able to be deducted in full from $200 to $500. This could potentially reduce compliance costs for the rental property investor and lower tax for the year.

Summary

As always, careful planning and the right advice can help alleviate some of the problems that can be faced when dealing with taxes. Changes in taxation legislation may affect the way some costs can be deducted against rental income. You should always consult with your chartered accountant before making any major decisions, and particularly before purchasing or selling rental properties, as they will have an up to date knowledge of any issues that may be relevant.

Disclaimer

No liability is assumed by Staples Rodway for any losses suffered by any person relying directly or indirectly upon the article above. It is recommended that you consult your advisor before acting upon this information.

Gavin Goodjohn is from Chartered Accountants, Staples Rodway Tauranga.

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