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Taxation (Budget Measures) Act 2010: Changes to building depreciation
Sections EE 31, EE 35(2), EE 48(1), EE 61, EE 64(2), EE 37, EZ 13(2), EZ 14(1) and schedule 39 of the Income Tax Act 2007
Budget 2010 introduced changes to the depreciation rate of buildings. The changes were intended to make New Zealand's tax rules more neutral by recognising that allowing depreciation on long-lived buildings and the application of depreciation loading on certain assets provides tax depreciation rates in excess of true economic deprecation rates.
The depreciation rate of buildings with long estimated useful lives has been changed to 0%. This new rate applies to all such buildings regardless of when they were purchased. This change is intended to make New Zealand's tax rules more neutral and non-distortionary.
Buildings with an estimated useful life of 50 years have been able to be depreciated for tax purposes at a rate of 2% per annum. However, analysis of New Zealand building price data between 1993 and 2009 shows that, on average, buildings have actually been increasing in value. This suggests that the 2% depreciation rate is not appropriate.
- The annual depreciation rate for buildings has been set to 0% if they have estimated useful lives of 50 years or more, as determined by the Commissioner of Inland Revenue.
- The annual depreciation rate has also been set to 0% for certain buildings that are excluded depreciable property and that are similar to the types of buildings with estimated useful lives of 50 years, as these do not have estimated useful lives.
- This new rate applies regardless of when a building was acquired.
- Building owners that have previously claimed a depreciation deduction on their buildings are still required to pay depreciation recovery if they sell a building for more than its tax book value.
- To ensure that the policy works as intended, special depreciation rates are no longer allowed for buildings. The definition of "temporary building" has also been amended.
Annual rate for buildings with long estimated useful lives
Sections EE 31, EZ 13 and EZ 14 have been amended to provide that buildings with an estimated useful life of 50 years or more will have an annual depreciation rate of 0% for tax purposes. This 0% rate is a statutory rate and overrides the rates set by determination issued by the Commissioner of Inland Revenue.
The changes to section EE 31 apply to buildings acquired during or after the 1995-96 income year, while the changes to section EZ 13 and EZ 14 apply to buildings acquired after 1 April 1993 but before the end of the 1994-95 income year.
These buildings are still depreciable property, but have a 0% annual depreciation rate. This means that the other depreciation provisions, such as those providing for depreciation recovery, still apply.
While the depreciation rate for these buildings is 0%, the depreciation rate for items used in, but not part of, these buildings remains unchanged, and they can continue to be depreciated separately from the building itself.
For residential rental properties, the interpretation statement, Residential rental properties - depreciation of depreciable assets (IS 10/01), sets out how to determine whether an item is part of a building or separately depreciable.
For non-residential properties, the Government has indicated that it will be reviewing which items can be depreciated separately from a building. If necessary, the tax rules will be amended before 1 April 2011 to clarify the law on this point.
Repairs and maintenance
These changes do not affect the deductibility of repairs and maintenance. While this can be a complicated matter, with the correct treatment often being a question of both fact and degree, some general guidance is set out below.
There is a two-stage approach to determine whether certain expenditure is deductible:
- Identify the relevant asset - that is, is the item being repaired/replaced part of a larger asset (such as the roof of a house), or is it a single asset (for example, a television).
- Ascertain the nature, extent and cost of the work undertaken. This will involve determining whether the work remedied wear and tear (generally deductible), or whether the asset has been improved or otherwise substantially changed (generally non-deductible).
In relation to step 2, some relevant factors are:
- If the expenditure does no more than restore an asset to its condition on purchase, it is likely to be deductible. This can hold even if the work is carried out over several years.
- This applies even if what is being replaced or repaired is improved, for example, because of new technology or better design, provided the work does not alter a substantial part of the asset.
- Expenditure on the renewal, replacement or reconstruction of a substantial portion of the asset goes beyond repair, and is generally not deductible repairs and maintenance.
- Work that results in a significant increase in an asset's value, or is unusually expensive, is more likely to be considered capital in nature.
As discussed above, a building can have many different parts. Repairing or replacing something that forms part of a building, provided it does not substantially improve or alter the value or function of the building, is likely to be deductible. If, on the other hand, a substantial amount of work is involved, or the building is improved in some way, it is likely that this will be non-deductible capital expenditure. For example, the replacement of a toilet that has fallen into disrepair in a residential house (which is part of the building as per IS 10/01) is likely to be deductible as repairs and maintenance. On the other hand, if the entire bathroom were to be re-designed and completely re-fitted, this is more likely to be a non-deductible capital improvement.
Definition of "building"
These amendments only affect the depreciation rate of buildings - there are no changes to the depreciation rates for structures. What a "building" is, for the purposes of the depreciation provisions, therefore becomes important. The Commissioner of Inland Revenue's view on this is set out in the recently released interpretation statement Meaning of "building" in the depreciation provisions (IS 10/02).
In essence, a building is a structure that has walls and a roof, is of considerable size, is meant to last a considerable period of time and is generally fixed to the land where it stands. For example, a house has the above features and so would be considered a building. However, a dam does not (it lacks walls and a roof), so would not be considered a building.
For more guidance on this issue, the interpretation statement IS 10/02 is available on Inland Revenue's website.
Interpretation of "estimated useful life"
An item's estimated useful life is the estimated useful life for that type of item, as set out in a determination issued by the Commissioner of Inland Revenue. Additionally, when interpreting an item's estimated useful life, the "whole of life" approach should be taken. For example, if a person purchases a second-hand item with an estimated useful life of 50 years, its estimated useful life will still be 50 years, regardless of how old the item actually is.
No special rate for buildings
Amendments to section EE 35(2) mean that special depreciation rates can no longer be set for buildings, regardless of their estimated useful lives. Special depreciation rates are granted in situations where a specific item's economic depreciation rate is either faster or slower than the rate set by the Commissioner of Inland Revenue. This change has effect from 20 May 2010.
The ability to apply for special rates for buildings is being removed as allowing these is inconsistent with the general view that buildings, do not on average, decline in value.
However, provisional depreciation rates can still be set for classes of buildings. If the Commissioner of Inland Revenue issues a provisional rate for a class of building stating that it has an estimated useful life of less than 50 years, owners of affected buildings will be able to claim depreciation deductions.
Provisional depreciation rates are granted when there is no applicable rate for the type of item owned, excluding the default class. To have a provisional rate granted, an owner must satisfy the Commissioner that the building does not come within an existing asset category.
Applications for provisional rates can be made using the form IR260A, available from Inland Revenue's website.
Special excluded depreciable property
Section EE 67 has been amended to provide a definition for "special excluded depreciable property". Special excluded depreciable property means all buildings not listed in new schedule 39.
In practice, special excluded depreciable property means buildings that were excluded depreciable property, and are similar to the current categories of building that have estimated useful lives of 50 years or more.
The asset classes listed in this schedule are from the depreciation rates issued by the Commissioner of Inland Revenue before 1 April 1993. In some cases, the names of these classes differ from those currently used in the depreciation determinations.
This definition of "special excluded depreciable property" is necessary because items of excluded depreciable property do not have estimated useful lives. It is therefore not possible to refer to these buildings using "estimated useful lives".
0% annual depreciation rate for special excluded depreciable property
Section EE 61 has been amended with new subsection 7B. This subsection provides that the annual depreciation rate for items of special excluded depreciable property that are excluded depreciable property is 0%.
This statutory rate overrides any depreciation rate issued by the Commissioner of Inland Revenue.
Buildings that are excluded depreciable property but not special excluded depreciable property will continue to be depreciated using the appropriate depreciation rates.
Change to the meaning of "temporary building"
Paragraph (a) in the definition of "temporary building" in section YA 1 has been repealed. This paragraph provided that a "temporary building" includes buildings issued under a permit by a local or public authority that stipulates that the building be removed or demolished at their request.
This change ensures that the proposed changes work as intended, as otherwise building owners could claim that their building was a temporary building under this paragraph of the definition.
Jack owns two buildings that he is currently allowed to claim depreciation deductions for. One building is a residential rental house and the other is a glasshouse.
For the 2010-11 income year, the applicable depreciation rates are 2% straight-line for the rental house and 5% straight-line for the glasshouse. This means Jack can claim depreciation deductions of 2% and 5% of the respective building's cost.
Depreciation determination DEP1 provides that the rental house currently has a useful life of 50 years and that the glasshouse has a useful life of 20 years. Therefore, for the 2011-12 income year, the applicable depreciation rates are 0% for the rental house and 5% straight-line for the glasshouse. This means Jack cannot claim depreciation deductions for his rental house, but can continue to claim them for the glasshouse at a rate of 5%.
The amendments largely apply from the beginning of the 2011-12 income year. For most people this is 1 April 2011, but if taxpayers have had a different income year approved by the Commissioner of Inland Revenue, they would apply from that date. For taxpayers with an early balance date, this may be as soon as 2 October 2010.
Provisional depreciation rates for categories of buildings
We have been asked to clarify what buildings we consider will be able to be the subject of an application for a provisional depreciation rate.
A taxpayer will be able to apply for a provisional depreciation rate for a class of building if the class of building is sufficiently different from the existing building classes in the Commissioner's table of depreciation rates so that the existing depreciation rates or building class descriptions do not seem accurate for the particular class of building under consideration.
From 1 April 2011, the economic rate for buildings with an estimated useful life of 50 years or more is 0%. However, provisional depreciation rates will still be able to be set for classes of buildings. If the Commissioner issues a provisional rate for a class of building stating that it has an estimated useful life of less than 50 years, owners of affected buildings will be able to claim depreciation deductions.
A person may apply for a provisional depreciation rate for an item when there is no applicable economic rate for the item (other than a default rate) in the Commissioner's table of depreciation rates: section 91AAG(1)(b) of the Tax Administration Act 1994. The Commissioner may decline to issue a provisional rate if there is an applicable economic rate for the item (other than a default rate) in the Commissioner's table of depreciation rates: section 91AAH(3)(a) of the Tax Administration Act 1994.
The Commissioner's table of depreciation rates includes economic rates for several classes of buildings based on the materials used in their construction. Examples of this are the asset classes "buildings with timber framing" and "buildings with reinforced concrete framing". To have a provisional rate granted, the building owner must satisfy the Commissioner that the class of building does not fall within one of the existing building asset classes. This will be based on the characteristics of the class of building itself, not the way that a particular building is used.
A purpose-built building has features that mean that none of the existing asset classes such as "building with reinforced concrete framing" apply to the building. These features may include a mixture of structural framing, including insulation panels for parts of the building requiring specialised temperature-controlled conditions and the use of other specialised building components. These features may mean the building has an estimated useful life of less than 50 years. In this case, a taxpayer may apply to the Commissioner for a provisional rate for the building.
A house used as a doctor's surgery, where the alterations do not fundamentally change the nature of the building in such a way as to affect its estimated useful life, would not meet the threshold for a provisional depreciation rate. In this case, a taxpayer would not receive a provisional rate for the doctor's surgery.
How to apply for a provisional rate
Applications for provisional rates can be made using the form IR260A, available from Inland Revenue's website.
If a provisional rate is issued it may apply to all taxpayers, to a group of specified taxpayers, or to a specific taxpayer