When a summer storm ripped through the country last year, one landlord thought the worst part would be the insurance claim. It wasn’t.

Instead, the real challenge came later, when their accountant explained that the extensive work required to restore the house, even though it was like-for-like, might instead be treated as capital expenditure rather than deductible repairs, depending on the condition of the property at the time the work began.

It’s a situation many property owners now find themselves in. Against this backdrop, Inland Revenue has released draft guidance on how to distinguish repairs from capital improvements. The most interesting parts of the draft are those dealing with the specific situations of leaky buildings and natural disasters.  

General tests

The start of the draft focuses on the legal tests to determine whether it’s capital expenditure. In general, this is a two-step test:

Step one: Identify the relevant asset

Step two: Determine the nature and extent of the work done to the asset.

While the underlying case law can be complex, Inland Revenue’s accompanying fact sheet provides a succinct summary. In essence, if the work produces a change in functionality or character of the asset, it is likely to be capital expenditure and not deductible. 

Specific situations

The draft becomes particularly instructive when applied to real-world circumstances. Inland Revenue focuses on two commonly encountered situations:

1. significant damage following events such as fires or floods, and
2. repairs to buildings with inherent defects, including leaky homes.

For both, the key message is consistent: it is the nature of the work undertaken that determines deductibility, not the cause of the damage.

1. Significant events

A frequent area of misunderstanding is the treatment of expenditure following a significant event such as a fire or flood.  While taxpayers often view the work as a straightforward “repair”, the draft highlights that the legal test requires a more nuanced comparison.

Inland Revenue’s view, consistent with case law, is that the asset must be compared at two specific points in time:

• the time immediately prior to the work commencing; vs
• the time immediately after the work is completed.

Therefore, there will usually be a change in functionality where the damage is significant.

For example, consider a rental property that is 80% destroyed by flooding.  At the time immediately before the repair commences, the property is probably not usable as a home and may not be rented out. Even if it is rebuilt to exactly the same standard as before, the work done will likely be capital because, at the relevant time for comparison, the house couldn’t be occupied.  This outcome may surprise many. 

Helpfully, the guidance also refers to a Canadian case in which extensive work following storm damage was held to be deductible. In that scenario, the property had experienced no maintenance for eight years, and the court found that the majority of the storm-related deterioration was attributable to deferred repairs. Because the work which combined wear-and-tear repairs, storm-damage remediation, and deferred maintenance formed a single overall project and did not result in a functional improvement, the full amount was deductible.

The draft suggests this may provide limited scope for deductibility in certain fact-specific situations. However, it should not be interpreted as encouraging taxpayers to defer maintenance, and Inland

Revenue signals that such outcomes will be uncommon.

2. Inherent defects including leaky buildings

The draft also addresses buildings with inherent defects, particularly leaky homes. The advice for leaky building owners may also produce some unexpected outcomes.

Here, the comparison points are the same: the asset as it exists immediately before work begins versus immediately after completion. Inland Revenue notes that such work is usually extensive.

Because the “before” condition of a leaky building includes the inherent defects, remediation work that restores the property to a sound condition will generally improve its character relative to that baseline. 

As Inland Revenue states, such work is “likely to go beyond a repair and change the character of the building (compared with its original defective character).” On this basis, comprehensive leaky-building remediation is usually capital.

However, minor work completed on a stand-alone basis should still be deductible if there is no change in character.  For example, replacing an individual flashing would usually still qualify as a deductible repair, provided it does not materially change the building’s overall character or functionality.

Given the growing number of weather-related events and the ongoing impact of historic construction issues, this section of the draft will be significant once finalised.