Depreciation – To Claim or Not to Claim – that was the question

After 1 April 2011, rental property investors won’t be able to claim depreciation on their investment if it has a useful life of 50 years or more – the IRD wants to stop this trend and recover more taxes.  Let’s face it, the IRD is all about recovery – not the lying in bed, staring at the ceiling kind, but the recovery of money through taxation – that’s what they do.  When they apply recovery to depreciation for investment properties they call this recovery a ‘clawback’ – a rather nasty little term for dragging back money you have received from them by way of reductions to your taxable income, on the basis that a property you have purchased for investment will depreciate over time and be of less value than the original price when you come to sell it again!  What’s wrong with this statement – even now with a depressingly flat market, how many investment properties have actually gone backwards to the extent that they could be said to have depreciated at the going rate of 4% per annum??? Wait a minute  – depreciation is only on the building  – land is not depreciated – that makes it a bit more understandable – land values don’t often go down overtime but buildings can if left to their own devices…

If you have been in the investment property market for a while now and bought your rental for, let’s say, $250,000 ($120,000 building $130,000 land value) and you have been claiming depreciation at around 3% per annum,  according to your tax bracket, you could have been reducing your taxable income by $3600 a year and paying around $1188 to $1800 less tax a year.  Taking the lower amount of $1188 (33% tax bracket) after 10 years of owning your rental you have paid around $11,880 less tax!  If after 10 years you have to sell or choose to sell, how many people would gamble that the building has gone down in value?  If the depreciation doesn’t happen on sale and you make an overall profit, your taxable income for that year of sale will grow overnight by $3600 x 10 years – work it out – the tax on $36,000 at the new tax rate of 30% would be $14,440 that you would have to pay back as a ‘clawback’ to IRD or the extra income may move you up a tax bracket!

How can you deal with this, we haven’t even talked about chattels yet.  One thing you could do is never sell your rental property and then you would not have to deal with a possible ‘clawback’.  Another way would be to save the depreciation in a special account so that it was there when you needed to pay it back or if you sell at a loss, to profit by.  You could sell at a loss – after 10 years even at the current property growth rate you may not expect to do this – yes the land will be the thing going up but if your property is well-maintained and kept in good repair or has any hint of character about it, you may be hoping for a rise in value of the buildings on sale.  You could have elected not to claim depreciation. The IRD was quite happy to oblige with the 1997 change that allowed taxpayers to choose this alternative.  You can’t change your mind mid-stream though – you might think that you could stop renting out and move in yourself – be careful, this is regarded as disposing of the property and the ‘clawback’ will occur.  I would guess that the depreciation claimed has been one of the perks for property investors who received an annual refund cheque and they may not have wished to give this up in the short term.  In future this won’t be an issue!

The best approach is to keep track of your property values – a valuation on disposal will give you the current situation and this will probably show that the building has gone down in value and the land has gone up – the difference between the book value (the building value on purchase less the depreciation you have claimed) and the new value will determine the clawback (or show there is no clawback due).  This will be the same with your chattels and there are very few of these that actually rise in value with long term use (although – think of a swimming pool)!  Your average rental fridge does not climb in value over time – so the clawback will be minimal if there at all for chattels and if some have gone up and some down they can be offset.  If you don’t get a valuation done on your property at sale you can expect the whole of the clawback to be a cost to you…

Brad Golchin, Accountant

Wise Advice – Xero Gold Partner

Tel: (09) 639 1004

Website: www.wiseadvice.co.nz