When are repair and maintenance costs deductible?

To say Kiwis are passionate about DIY is probably an understatement. But a recurrent issue faced by many New Zealand taxpayers is whether what they spend on “repairs and maintenance” is tax deductible, or whether it must be capitalised. The answer to this is often not clear cut.

The IRD recently released an Interpretation Statement*, confirming that expenditure on repairs and maintenance is only tax deductible if:

• The repair and/or maintenance is necessary to support the individual’s income earning process
• It is not of a capital nature.

A number of useful and relevant examples are included below and within the Interpretation Statement.

While determining whether repair and maintenance expenditure is of a capital or revenue nature is a fact specific matter, the courts have established a general two step approach to assist with the process. Step one identifies the relevant asset that is being repaired or worked on while step two focuses on the nature and extent of the work that is undertaken on the asset.

Step 1: Identifying the relevant asset

This is always a question of fact, degree and impression. Rather than focusing on a profit-earning structure or entity the courts favour the “entirety test”. The key considerations for this test are:

• Is the asset complete in itself and not part of an asset or aggregation of things forming an asset?
• Is the asset physically and functionally distinct from its wider setting?
• Is the asset capable of separate operation as an entirety by itself?

Step 2: Nature and extent of the work done

Work undertaken on an asset that results in the reconstruction, replacement or renewal of the asset (or substantially of the whole asset) is deemed to be work of a capital nature.

Expenditure that changes the nature of the asset or leads to improvements that could not be achieved via routine repairs and maintenance would also be labelled capital expenditure.

A tax deduction may be allowed for repair costs required to bring a newly acquired asset up to the condition necessary for it to be used in the taxpayer’s business. However this is based on the presumption that the purchase price of the asset was not reduced to reflect the repair work that had to be undertaken. If the purchase price of the asset was reduced, the expenditure is likely to be held on capital account.

Below we highlight a few examples in relation to the deductibility of repairs and maintenance expenditure.

A temporary break in rental activity

Repair and maintenance work that is undertaken on a temporarily vacated rental property to make it more attractive to potential tenants is directly related to the property owner’ s ability to derive an income; provided they still plan to rent the property once the work is complete. The amount spent on repair and maintenance in this case would be tax deductible.

Ceased rental activity

If a taxpayer decides to move into their rental property after the maintenance is complete and therefore no longer receive rental income from the property then the amount spent on repair and maintenance would not be tax deductible. thn.

Introducing a new asset

The cost of insulating a rental property that was previously un-insulated would be held on capital account as a new asset is being introduced into the property. Therefore the nature of the property has been altered. As a result the amount spent on insulation would not be tax deductible.

Replacing or repairing an existing asset

The cost of insulating a rental property that was previously insulated is likely to be held on revenue account on the basis that the work only restores the property to its former condition and the repair does not change the character of the asset. Therefore in this case the insulation would be tax deductible.

Note that the outcome may differ depending on the materials that are used to repair an existing asset. Where a material that is required for repair work is no longer available or is no longer able to be used due to regulations, then using a comparable or equivalent alternative may still be held on revenue account even though a newer, more modern material is used i.e. spend is tax deductible . If a taxpayer simply decides to upgrade to more durable material in place of the existing material which is readily available the expenditure may be held on capital account as it changes the nature of the asset i.e. spend is not tax deductible .

Leaky home repairs

Repairs undertaken on a “leaky home” would be tax deductible if the work done does not amount to a reconstruction, replacement, or renewal of substantially the whole of the house. For example, if recladding work is undertaken while repairing a “leaky home”, then the cost of re-cladding is likely to be a deductible repair if the existing cladding is replaced with a similar product that does not improve the asset or value of the property. However if the cladding is replaced with a superior product that improves the value of the home, then the cost incurred may be capital in nature and therefore not tax deductible.

These and other useful examples are noted within the Interpretation Statement.

Whilst the Interpretation Statement provides a good starting point to help determine tax deductibility in the future, we recommend you still seek appropriate tax advice, particularly where the numbers are material.

To ensure you are seen to have taken reasonable care in taking a tax position, it may be necessary to seek a formal opinion on the matter. Your Hayes Knight adviser or our Tax Director Phil Barlow would be happy to help in this regard.

Phil Barlow
Tax Director
T: +64 9 448 3233
E: phil.barlow@hayesknight.co.nz

*(IS 12/03) entitled Income Tax – deductibility of repairs and maintenance expenditure – general principles, which seeks to clarify the position for taxpayers.