Recent Tax Case: Capital Expenditure vs. Repairs in a Rental Property

In a recent tax case, Lawrence v Commissioner [2024] NZHC 905, the court provided clear guidance on the distinction between capital expenditure and repairs in relation to rental property maintenance. This decision aligns with previous tax cases but highlights that the issue of repair vs. capital expenditure remains a confusing and controversial topic among taxpayers. Many errors and misunderstandings are frequently encountered by both taxpayers and Inland Revenue (IRD) in this area.

Case Overview

In Lawrence v Commissioner, sections DA 1 and DA 2 of the Income Tax Act 2007, along with deductible expenditure and capital limitations, were discussed. The case involved issues of basic maintenance and repairs, including addressing leaky building concerns.

The taxpayers purchased a rental property in Tauranga. Prior to the purchase, building inspections revealed no significant issues, but after the purchase, water leaks were discovered. Initial remedial work was done, but it soon became evident that major remediation was required. Later on, building consent was sought, and additional work was done to fix the problem permanently. This included removing the roof, replacing joinery, and making other significant repairs.

Although these issues were likely due to poor design and construction, the taxpayers had little choice but to fix the property, as they couldn't sell it with known weather-tightness problems. They were left with no option but to undertake substantial repairs.

Legal Issue

The primary legal issue in this case was whether the expenditure incurred was deductible under section DA 1, or whether it was a capital limitation as per section DA 2 of the Income Tax Act.

Section DA (2)(1) denies the deduction for expenditure to the extent that it is capital in nature. The essential question was whether the remediation work that the Lawrences undertook were repairs and therefore of a revenue nature.

Court's Analysis

The court applied the following tests:

1. Reconstruction, Replacement, or Renewal of the Asset: Did the work result in the reconstruction, replacement, or renewal of substantially the whole asset?

2. Change in Character of the Asset: Did the work alter the character of the asset?

3. One Project of Work: Did the work form part of one larger project?

Change in Character

The court found that the remedial work significantly improved the property from its original construction. It altered both the appearance and performance of the building, enhancing its durability and usability. Specific improvements included:

• Replacement of guttering

• Installation of new cavity systems

• Improved water disposal systems

Reconstruction, Replacement, or Renewal

The court also concluded that the extent of the work supported the view that the asset was reconstructed and renewed. The work was substantial, involving:

• Removal and replacement of all external elements of the building, including the roofline.

• Exterior work, such as painting, replacement of structural elements, and installation of a new stormwater drainage system designed by an engineer.

• Internal renovations, including timber framing, wall replacements, new flooring, insulation, and electrical work, as well as internal plastering and painting.

The remediation was not merely a replacement of defective parts; it was a large-scale project that affected nearly every part of the property.

Taxpayer's Argument

The taxpayers argued that the work was simply remediation, aimed at restoring the property to its original state for the continuation of generating rental income. They contended that no new asset was created.

Court's Conclusion

However, the court disagreed, concluding that the test was not whether a new asset had been created, but whether the work resulted in a significant extension of the building's useful life. The court found that the expenditure provided enduring benefits to the taxpayers in their rental accommodation business. Therefore, the expenditure was deemed to be of a capital nature, meaning it was not deductible under section DA 1.

At [69] In accordance with the leading Privy Council decision, Auckland Gas Co Ltd v Commissioner of Inland Revenue (Auckland Gas), there is a two-step enquiry to determine the nature of the expenditure: (a) The first step involves identifying the asset/object on which work has been done. (b) The second step requires identifying the nature and extent of the work on the physical object to ascertain the effect of the work on the asset/object.

And at  [70] In addressing the issue of the nature and extent of the work, the following tests are applied: (a) whether the work resulted in the reconstruction, replacement, or renewal of substantially the whole of the asset; (b) whether the work changed the character of the asset; and (c) whether the work formed one project of work.