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Renovation expenditure is denied being deductible expenses for rental properties by IRD.

A recent legal case concerning the renovation of residential rental properties has garnered significant attention from investors. Details of which were outlined in TDS 24/02 Renovation work on recently acquired properties and the capital limitation.

Facts

The taxpayer in question is a trust that acquired multiple rental properties, most of which were already tenanted at the time of purchase. Subsequently, the taxpayer carried out renovation work on these properties, which included various upgrades such as replacing kitchen units, installing dishwashers and heat pumps, upgrading bathroom fittings, replacing carpets and vinyl, repairing and repainting both exterior and interior walls, and conducting roof maintenance.

In their income tax return, the taxpayer claimed the entire cost of these renovations, arguing that they were necessary to restore the properties to their original condition and no enhancements were made. However, this claim was contested by the Inland Revenue Department (IRD), which maintained that the expenditure constituted capital investment rather than deductible maintenance costs.

Legal Issue

The issue was whether the capital limitation in s DA 2(1) applied. Section DA 1 is subject to the general limitations in s DA 2. Under s DA 2(1), a person is denied a deduction for an amount of expenditure to the extent to which the expenditure is of a capital nature.

The crux of the issue rested on whether the expenses incurred by the taxpayer should be considered part of the properties' acquisition costs. The IRD's objections centred on three main factors:

  1. The initial condition of the properties at the time of purchase.
  2. Whether a discount on the purchase price was given to account for the condition of the properties.
  3. The cause of the need for the work.

 
Rental Property Capital Expenditure Analysis

According to the IRD, if a capital asset was not in satisfactory condition upon acquisition, the expenses incurred to make it suitable for use were more likely to be deemed part of the acquisition cost rather than maintenance costs. This determination hinged on whether the taxpayer recognized the need for additional expenditure to bring the asset to the desired condition for long-term use at the time of acquisition.

Furthermore, if the purchase price of a property was reduced because it needed repairs, then the money spent on those repairs is considered part of the acquisition cost. On the other hand, if the purchase price remained the same regardless of the property's condition, the repair costs are more likely to be deductible. It's important to note that there doesn't have to be a specific agreement regarding a discount; what matters is whether it's reasonable to think the seller could have asked for more money if they had fixed the issues themselves. Courts have also ruled that even if the need for repairs wasn't known at the time of purchase and therefore wasn't factored into the price, the repair costs may still be considered capital expenses, meaning the overall cost of acquisition was higher than anticipated.

Additionally, the timing of the need for renovation work relative to the taxpayer's acquisition of the asset played a crucial role. The earlier the need for renovation arose, the more likely it was considered part of the acquisition cost.

Conclusion, usually when we judge whether the maintenance cost is capital in nature, common sense we will see if the current assets are replaced or being fixed, also we are looking at the type and extent of the work done. In this case IRD brought an idea that whether the repairs happened right after acquisition of properties can be treated as part of the cost of acquisition. This raises an alert for all future investors to treat and report their return in a more careful way.

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