When the property cycle starts to look like it is peaking, the temptation to sell comes calling…..so it may be worth thinking about all the depreciation claimed on your investment property. Does it all have to be repaid if the property is sold for more than you purchased it? Not necessarily.
This post comes courtesy of Ross Barnett at Coombe Smith Chartered Accountants in Hamilton. Ross is a specialist in investment property tax matters, owns investment properties himself, and is active helping others on boards such as Property Talk forums. You can contact Ross at email@example.com or by phone on (07) 839 2801.
Without further ado…
Quite a few property investors are thinking about selling, so I thought it was very timely to send through this article written on reducing depreciation recovery.
Should you just accept that you will have to recover all the building depreciation you have previously claimed? ……… NO
In many cases, the building depreciation recovered is only a fraction of the total claimed and there are a number of ways to minimise it.
What is Depreciation Recovery?
In the past, property investors have been able to claim Building Depreciation. An investor may have purchased an investment property for $350,000 of which $200,000 is land, $125,000 is building and $25,000 is chattels like carpets and curtains that have been valued by a Valuit Chattels valuation. Most investors would have claimed 3% or 4% diminishing value depreciation on the $125,000 (or around $3,500 to $5,000) per year. They also would have depreciated the chattels at their respective depreciation rates. So over 5 years the investor may have claimed $20,000 of building depreciation, bringing the book value of the building down to $105,000.
In the past, the IRD has given a deduction for the reduction in value of the building. If the building hasn’t been reducing in value, has increased in value, or has reduced at a lesser rate, then the property investor has been over-claiming building depreciation. They have been claiming a deduction which is perfectly legal and allowable, but that isn’t really occurring in their circumstances.
When the building is sold, an investor who has been over-claiming this deduction, will then have to pay all or a part of it back again, which is depreciation recovery.
- Depreciation Recovery generally only applies to buildings.
- Chattels generally reduce in value at similar levels to IRD rates. Therefore, when the investment property is sold, there is no recovery. A chattels valuation could be obtained at date of sale to prove this.
Carrying on using the example given above, if the investment property is now sold 5 years later for $500,000. The chattels might be worth $10,000, the building $190,000 and the land $300,000. The building book value is only $105,000, so the $20,000 building depreciation claimed over the 5 years will be recovered and become taxable income. From $125,000 to $190,000 is a $65,000 capital gain, which is currently non taxable in New Zealand. In this example, the difference between the real building value $190,000 and the book value $105,000 is large, so there would be full depreciation recovery with no chance of reducing. If the values are a lot closer, then there are a number of opportunities to reduce this.
How to reduce Building Depreciation Recovery?
1) Make sure your accountant or the person calculating the recovery knows what they are doing. I have recently seen an example where an accountancy firm showed a recovery of $16,700 approximately when the recovered amount should have been $5,600 maximum. This is a difference of $11,100 taxable income, or at the 33% tax rate $3,663 extra tax paid for no reason. This is a great reason to use a real ‘property accountant’, someone who specialises in and understands property.
2) A starting point to establishing the building value is normally the rates valuation. From the rates information, work out what percentage is building and then apply this to the sale figure (less deductions!). If this figure is over your building book value, then there will be building depreciation recovery (presuming you have claimed building depreciation in the past).
3) If the rates figure and the book value are similar, you could look at writing a clause in the contract. The parties agree the building value is $XXXXX.
- Example – The building cost $125,000 and closing book value is now $105,000 so $20,000 building depreciation claimed. The sale value is $300,000 and based on the rates valuation the building should be worth $112,500. The parties could write a clause in the contract, “The parties agree that the building value is $105,000”. As long as the two parties are not related, then this is the sale price.
- You should not be too aggressive with this approach and the building value needs to be reasonable.
4) Any legal fees for the sale will be claimable under the new legal fees deduction rules.
5) Any commission or other costs incurred for the sale need to be deducted from the sale price, before the building value is calculated.
6) If you are confident the building value is close to the closing book value, then you could obtain a registered valuation to prove this. We frequently do this for clients, as the rating valuations are not always realistic or are out of date. Recently a client saved over $20,000 in depreciation recovery, or over $7,000 in tax at the 33% tax rate, just by obtaining two valuations for less than a cost of $500.
Overall, don’t just accept a depreciation recovery. Think it over, ( “Has my gain come through land or building?” and “Has my building really decreased slightly in value?”), justifying any previous depreciation claims, and meaning there should be little or no depreciation recovery.
Coombe Smith Chartered Accountants
Normal Office Hours: Monday – Friday, 8am – 4pm
Phone: (07) 839 2801
Fax: (07) 839 2802
Level 1, 851 Victoria St,
PO Box 9317, Hamilton