Quite a few property investors are thinking about selling, so I thought it was very timely to send through this article I wrote in 2013 on reducing depreciation recovery.
Should you just accept that you will have to recover all the building depreciation you have previously claimed? ……… NO
In many cases, the building depreciation recovered is only a fraction of the total claimed and there are a number of ways to minimise it.
In the past, property investors have been able to claim Building Depreciation. An investor may have purchased an investment property for $350,000 of which $200,000 is land, $125,000 is building and $25,000 is chattels like carpets and curtains that have been valued by a Valuit Chattels valuation. Most investors would have claimed 3% or 4% diminishing value depreciation on the $125,000 (or around $3,500 to $5,000) per year. They also would have depreciated the chattels at their respective depreciation rates. So over 5 years the investor may have claimed $20,000 of building depreciation, bringing the book value of the building down to $105,000.
In the past, the IRD has given a deduction for the reduction in value of the building. If the building hasn't been reducing in value, has increased in value, or has reduced at a lesser rate, then the property investor has been over-claiming building depreciation. They have been claiming a deduction which is perfectly legal and allowable, but that isn't really occurring in their circumstances.
When the building is sold, an investor who has been over-claiming this deduction, will then have to pay all or a part of it back again, which is depreciation recovery.
Depreciation Recovery generally only applies to buildings. Chattels generally reduce in value at similar levels to IRD rates. Therefore, when the investment property is sold, there is no recovery. A chattels valuation could be obtained at date of sale to prove this.
Carrying on using the example given above, if the investment property is now sold 5 years later for $500,000. The chattels might be worth $10,000, the building $190,000 and the land $300,000. The building book value is only $105,000, so the $20,000 building depreciation claimed over the 5 years will be recovered and become taxable income. From $125,000 to $190,000 is a $65,000 capital gain, which is currently non taxable in New Zealand. In this example, the difference between the real building value $190,000 and the book value $105,000 is large, so there would be full depreciation recovery with no chance of reducing. If the values are a lot closer, then there are a number of opportunities to reduce this.
Overall, don’t just accept a depreciation recovery. Think it over. “Has my gain come through land or building?” and “Has my building really decreased slightly in value?”.... justifying any previous depreciation claims, and meaning there should be little or no depreciation recovery.
Ross Barnett - Principal and Property Accountant
Coombe Smith, Waikato