TelferYoung Limited

Current | 2011 | 2010 | 2009 | 2008 | 2007 | 2006

Property Cost Allocation - Revisited

9 July 2008

Despite ongoing reviews of depreciation policy by the Inland Revenue Department (IRD) investment property still offers significant tax savings over many other forms of investment through the use of different depreciation rates for various parts of the property.

At the time of purchase there is an opportunity to legally maximise both future tax savings and cash flows.  Early planning and professional advice can be critical to obtaining the sometimes significant cash flow savings.  The key categories of tax saving are well known.  In order of significance (assuming a typically geared property) the categories are as follows:

1. Mortgage (interest only)
2. Depreciation
3. Repairs & Maintenance
4. Insurance, Rates etc.

All expenses except depreciation are more or less fixed, and difficult to control.  They are also all cash items.  Depreciation on the other hand is a non-cash item designed to allocate the value of an asset over its useful life, primarily for tax purposes.  It is the only expense item that does not actually cost you anything.  Therefore you want to maximise it.

The Inland Revenue Department (IRD) is currently reviewing its residential investment depreciation policy which we understand will not allow higher depreciation claims on items which are considered to form an integral part of the structure.  Items listed on the IRD's residential rental chattels depreciation schedule (IR265 March 2007) such as carpets, whiteware, light fittings, heating systems will still be able to be depreciated separately.  Indeed for all non building assets acquired from 1 April 2005, the new depreciation rates will be higher for the 2006 and later tax years, based on a new diminishing value formula of 2 ÷ by the Inland Revenue estimated useful life, rounded to the nearest schedule rate.  The threshold for the asset determination rate increased on 19 May 2005 to $500 - this means assets costing less than this amount can be expensed in full in the year that they are purchased, provided they are:

• Not purchased as part of the initial investment
• Did not comprise part of a larger asset, e.g. table purchase as part of a dining suite
• The combined sum of goods purchased from the same supplier on the same date for items carrying the same depreciation rate do not exceed the $500 threshold.

Items which have been depreciated separately in the past, and which are viewed as forming an integral part of the structure, e.g. fitted kitchen joinery, electrical reticulation, plumbing, plumbing fixtures, partitions etc., must be added to the cost of the building on the next tax return, together with the accumulated depreciation.

Typically when a residential property is purchased, the price of land and buildings is apportioned for tax purposes on a simple pro rata basis in relation to the rating valuation.  The value of the improvements assessed by the rating valuation, as a percentage of the total value, is applied to the purchase price and the resulting estimate of the building value is used for depreciation purposes.  However utilising this apportionment may overstate the land component of the total value, as land under the Rating Act is valued ‘as if vacant'.

Commonly, depreciation is assessed on the basis of an all encompassing rate of 3% applied to the pooled "building assets".  There is no depreciation on land.  This methodology is accepted by the Inland Revenue Department, but in most instances represents lost opportunity in terms of potential tax deductions.   Apart from the basic structure, the majority of residential buildings will include various non essential fit out assets and chattels, the IRD still recognises that these assets have a shorter life than the building structure, and as such these assets carry significantly higher depreciation rates.  Therefore it is clearly beneficial not to pool assets which will be depreciated at the default 3% rate, rather to identify separately those assets that attract higher depreciation rates. 

Examples of residential rental property chattels and associated depreciation rates (on a diminishing value basis) are as follows:

The above rates are subject to a 20% loading if purchased new.  The IRD says property owners who have been splitting essential components out from the cost of the building (such as wiring and plumbing) will have overstated their depreciation claim in the past, but will not be asking them to repay the money.  Property owners will be required to add the value of the various ‘components' they have been depreciating individually into the cost of the building, and combine the depreciation claim for those individual assets.  The building should then be used to claim depreciation at the correct rate.

What is the Process?

TelferYoung will undertake a detailed inspection of your property and provide a full report or Property Cost Allocation (PCA) which apportions purchase price according to IRD prescribed asset categories and depreciation rates.  The IRD list is extensive and apart from the sample above, also includes rates for assets associated with hotels, motels, rest homes, cinemas, restaurants and farms.  The Property Cost Allocation identifies book values to each individual asset to allow specific depreciation to be calculated. 

The preparation of this report is a one off process which will provide benefits each year until the property is sold.  It is important to note however that the transferring of properties to an LAQC or Trust can only be depreciated on the original purchase price.

What are the Benefits?

Based on the proposed IRD changes, the following example sets out the benefit in having a depreciation apportionment completed by TelferYoung:

Additional depreciation of $5,354 in the first year is achieved by completing the apportionment.

This example outlines the extra depreciation which may be claimed for a rather basic rental property.   The savings are typically much greater for well-appointed properties, or partially or fully furnished properties.   An example of a property with a comprehensive chattels list would be a serviced apartment.

Summary

You must claim depreciation on a house or flat you are renting out as a deduction from the rent you receive, unless you make an election for the asset not to be a depreciable asset.  When you go through the process of establishing your opening book values and depreciation basis, why not get it right and maximise your tax deductions and property's cash flow.  By maximising your allowance, tax deductions are increased.  IRD regularly carry out investigations into rental properties, this includes depreciation claimed.  TelferYoung can provide robust methodology to maximise your returns.

Chris Barnsley

This monthly paper reflects the views of the writer and may not represent the views of all TelferYoung staff.