Tax Deductibility and Healthy Homes standards
In mid-August, Inland Revenue released Questions we’ve been asked QB20/01 Can owners of existing residential rental properties claim deductions for costs incurred to meet Healthy Homes standards? Owners of residential rental properties are required to meet certain minimum standards which are commonly known as the Healthy Home standards and refer to both the 2016 and 2019 regulations.
Costs incurred on revenue account are generally considered deductible in the income year in which they are incurred. This can include costs such as repairs and maintenance, costs involved in minor additions or alterations as long as they do not change the character of a building, costs involved in record keeping and providing information in tenancy, and the costs involved in replacing items on a like-for-like basis in the future where they have been previously treated as part of the building.
QB 20/01 also considers how depreciation can be applied to capital costs. Capital costs are incurred in situations like the purchase of land, building, construction and equipment to be used in the production of goods or the rendering of services. Usually, depreciation losses can be deducted for these expenses unless they are for something that is part of the residential rental building. The cost of items that is part of the building are added to the building's cost and depreciated at the same rate as the building. This is usually done at zero percent.
Inland Revenue has advised that the items likely to be considered part of the building are:
- Smoke alarms;
- Ducted or multi-unit heat pumps;
- Flued fires (wood or gas);
- New or replacement openable windows;
- New exterior doors;
- Most extractor fans or range hoods;
- Ground moisture barriers; and
- Drainage systems for storm, surface, and groundwater and drainage of water from roofs.
Whether the expenditure is capital or revenue in nature requires careful analysis of the specific facts. Generally, expenditure incurred to meet the Healthy home requirements will be capital in nature. This is where the work results in the reconstruction, replacement, or renewal of the whole asset or substantially the whole asset, or goes above merely making good any wear and tear on the asset which ultimately changes the character of the asset. Expenditure incurred on work to repair or maintain an asset without changing the character of the assets or reconstructing, replacing, or renewing, most or all of the asset will be revenue in nature.
QB20/01 goes on to provide a detailed guide to assist in determining the issues summarised above on a more individual basis.
Identifying the relevant asset
In order to determine whether your expenditure is capital or revenue, the first step must be to identify the relevant asset.
The Commissioner provides a three-step test that is employed in assessing whether expenditure has been incurred for an item which is a separate asset, or part of a larger asset, as follows.
- Determine whether the item is in some way attached or connected to the building. QB20/01 notes that step one is almost always met in the context of a Healthy Homes expenditure.
- Determine whether the item is an integral part of the property to the degree that the property could not function without it. If so, then the item will be part of the residential rental building. The application of step two requires assessing what features or items comprise the relevant asset, this being the residential rental building. For example, as the 2016 regulations require smoke alarms and insulation they are now an integral part of the property and the residential rental property would be considered incomplete without them. Most of the standards imposed under the 2019 regulations are integral to a residential rental property, and as such will meet step two leaving no need to move to step three.
- Determine whether the item is built-in or attached or connected to the building in such a way that it is part of the ‘fabric’ of the building, thus forming part of the residential rental property. If this is not met then the item is a separate asset. Step three requires consideration of whether the item has lost its physical distinctness or separateness from the building once it has been installed. This is of particular relevance to things like moisture ingress and drainage requirements.
Nature and extent of work carried out
QB 20/01 explains that after identifying the relevant asset the next step is to consider the nature and extent of the work undertaken in relation to that asset. Further explanation of this can be found in IS 12/03. The work undertaken can be repairing or maintaining existing parts of the building, which would classify it as ‘repairs’. In the context of Healthy Homes’ standards, the work carried out will usually not extend to reconstruction, replacement, or renewal of the whole or a substantial part of the building. However, it may improve or enhance the building, effectively changing its character. This is very fact specific and careful analysis of each project is required as there is no blanket rule. Expenditure on one item in one rental property could end up being treated differently in relation to another property.
Where the costs are capital in nature, the expenditure is either added to the value of the building, known as capitalising the costs, or if the expenditure related to a separate asset then it can be depreciated.
When items are not part of the building, the capital costs will be depreciated in one of two ways:
- Depreciation over multiple income years using a rate set out in Depreciation Determination DEP80: Residential rental property chattels for assets of that type.
- Depreciation at a rate of 100% in the income year the expenditure is incurred if the item is a “low-value asset”.
The Commissioner has put particular thought into items involved in the Health Home standards that may be depreciated. These items capable of being separately depreciated (and therefore, open to being fully depreciated as a low-value asset include some electric panel heaters, some heat pumps, through-window extractor fans, window stays, door openers and stops, external door draught excluders, and some devices for blocking fireplaces or chimneys.
It is important to note that if the asset is part of a group of items acquired at the same time, from the same supplier, the total cost of the group of assets must not exceed the relevant amount.
Where costs incurred to meet the Healthy Homes standard are capital in nature, the expenditure is treated either as adding to the capital value of the building and subject to the depreciation treatment applicable to the building, or the cost of an asset that is separate from the building.
It is important to note that future expenditure replacing an item that has been treated as capital in nature when applying the policy in QB 20/01 will be a repair to the building, and therefore, revenue in nature. Conversely, where an item has been treated as a separate asset by applying QB 20/01, and is later replaced, that expenditure is likely to be considered capital in nature.
For more information on the deductibility of costs incurred by existing owners of residential rental properties in meeting Healthy Homes standards, read the full Inland Revenue statement: https://www.taxtechnical.ird.govt.nz/questions-we-ve-been-asked/2020/qb-20-01
This is a very high level summary of some of the tax rules and operational statements and does not constitute legal advice. For personalised advice on your situation, please contact us.