Navigating Renovation Costs for New Rental Property Owners

Inland Revenue has just released a useful Tax Council Office (TCO) decision regarding the deductibility of renovation work carried out on rental properties which have recently been purchased.

The outcome is not surprising, but the decision serves as a useful reminder for new rental property owners that common repair/replacement costs (which would ordinarily be deductible repairs and maintenance expenditure) can be capital and non-deductible where incurred close to the time of purchase; especially where there is an intention to make such improvements at the time of purchase.

What happened in the case?

The work carried out soon after purchase included replacing kitchen units and appliances, heat pumps, bathroom fittings, carpets, repairing walls and roofing and painting on a number of rental units acquired by the purchaser.

The new owner sought an immediate deduction for some of these renovation costs, however upon review Inland Revenue concluded that all the work undertaken was capital in nature, part of the cost of acquisition of the properties, and no element of the spend was allowed as an upfront deduction for ‘repairs and maintenance’ (R&M) expenditure.

What was the basis for Inland Revenue’s position?

Where a capital asset is not in good working order at the time of acquisition, the cost of restoring the asset or component to a condition suitable for intended use is more likely to be a part of the cost of acquisition, rather than a routine maintenance cost.

In the decision, the TCO concluded that the test is whether the upgrade/renovation work is necessary for the asset’s suitability over the owner’s long-term use, and not just whether the asset is capable of being used in the purchaser’s business immediately (i.e. habitability). However, if there is any risk or danger arising from the condition of the property requiring urgent remedy, this can help to indicate the costs are deductible R&M.

It was also established by the TCO that the purchaser acquired the properties with the intention of renovating them, making them more attractive to prospective tenants who would pay more rent, and potentially take better care of the properties. In their view this was a key factor, and an intention to improve rental yield and protect the income stream indicated the costs were capital, even though at the time of purchase most of the units were already tenanted.

In this sort of situation, it does not matter whether the need to undertake a repair was known or not at the time of purchase. This means if the poor condition is only discovered by the purchaser after settlement, it may still be treated as part of the cost of acquisition. However, where the cause or need for the work can proved to have arisen after purchase, this can allow for the repair work to be deductible under normal R&M deductibility rules.

The final major factor considered was whether the purchase price was discounted due to disrepair. This indicates that the subsequent costs to remedy the condition of the asset is capital (part of the cost of acquisition).

Note, this does not require a specific discount to be negotiated, just an inference that the vendor could have obtained a higher price, had the renovation work been undertaken by them prior to sale. Based on the evidence obtained, the TCO in this case concluded that the taxpayer paid less than the expected market value for each property. The taxpayer had also acknowledged the scale of the repair work in correspondence with the vendor, and must have had in mind the costs of the work during the negotiation process.

What does this mean?

This case reinforces that new rental property owners should not necessarily plan on always getting the tax benefit associated with this type of renovation work.

Sometimes initial R&M expenditure can be deductible, where there is risk or danger associated with the asset’s current condition, or where the damage being remedied has actually occurred after purchase.

If a rental property is acquired with the intention of upgrading it to make it suitable for the purchaser’s long-term business use, this is a strong indicator that the spend will be capital in nature.

It does not necessarily matter whether a specific discount is negotiated due to the disrepair, or even whether the disrepair is known or disclosed at the time of purchase.

It’s always a good idea to get your usual Nexia tax Advisor involved early in the process, and to discuss your plans with them around this type of renovation work. We can confirm the likely treatment and look at any opportunities to provide a tax efficient outcome. This can help to avoid a nasty surprise at tax return preparation time.

Talk to our experts

For expert insights and assistance in navigating the complexities of owning a rental property, reach out to your local Nexia Advisor. If you are not already a Nexia client and you are looking for specialist tax advice or strategies for effective tax planning, contact us to explore how we can help.

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