Reducing Depreciation Recovery - Recap!

23 November 2015

Reducing Depreciation Recovery - Recap!

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.


What is Depreciation Recovery?

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.


How to reduce Building Depreciation Recovery?

1) Make sure your accountant or the person calculating the recovery knows what they are doing.  I have recently seen an example where an accountancy firm showed a recovery of $16,700 approximately when the recovered amount should have been $5,600 maximum.  This is a difference of $11,100 taxable income, or at the 33% tax rate $3,663 extra tax paid for no reason. This is a great reason to use a real ‘property accountant’, someone who specialises in and understands property.

2) A starting point to establishing the building value is normally the rates valuation.  From the rates information, work out what percentage is building and then apply this to the sale figure (less deductions!).  If this figure is over your building book value, then there will be building depreciation recovery (presuming you have claimed building depreciation in the past).

3) If the rates figure and the book value are similar, you could look at writing a clause in the contract.  The parties agree the building value is $XXXXX.

a.  Example – The building cost $125,000 and closing book value is now $105,000 so $20,000 building depreciation claimed.  The sale value is $300,000 and based on the rates valuation the building should be worth $112,500.  The parties could write a clause in the contract, “The parties agree that the building value is $105,000”.  As long as the two parties are not related, then this is the sale price.

b. You should not be too aggressive with this approach and the building value needs to be reasonable.

4) Any legal fees for the sale will be claimable under the new legal fees deduction rules.

5) Any commission or other costs incurred for the sale need to be deducted from the sale price, before the building value is calculated.

6) If you are confident the building value is close to the closing book value, then you could obtain a registered valuation to prove this.  We frequently do this for clients, as the rating valuations are not always realistic or are out of date.  Recently a client saved over $20,000 in depreciation recovery, or over $7,000 in tax at the 33% tax rate, just by obtaining two valuations for less than a cost of $500.

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.

Kind regards
Ross Barnett 

Hamilton Market and Possible Predictions

30 November 2015

Hamilton Market and Possible Predictions

Here is a copy of the median sale price graph from the Lodge Real Estate website.

(Click here to view on Lodge Website)

 This shows how much the Hamilton market has changed in the last eight months:

• March 2015     $350,000
• October 2015  $435,000

So an increase of $85,000 or 24% in eight months!
 

Last Booms

Looking at the earlier information in the graph, you will see the last boom started around October 2002 ($154,000) and continued for around five years to September 2007 ($365,000).

So, over this five year period, the median sale value increased $211,000 or 137%.

The boom before that, from September 1992 ($105,000) to November 1997 ($168,250), was also around five years, with a gain of 60% over this time period.

Flat Periods

• September 2007 to March 2015, approximately 7.5 years, with decrease of $15,000!
• November 1997 to October 2002, approximately 5 years, with decrease of $14,250!

Trend and Prediction

So the booms are getting bigger in terms of percentage increase, but the flat periods are also getting longer.

Based on history, you would expect the current boom to go for around five years, so until March 2019.

However, the growth, or increase in value, has been extreme over the last eight months.  This would hint that the current boom will be shorter, as it should be impossilbe to sustain that level of growth for a long period.

You also have to take into account the changes to the World economy, changes to LVR, and future changes the Government could introduce.  For example, if the Government / Reserve Bank introduce borrowing limits based on income (such as the 4.5 times income that has been talked about), this could have a huge effect on the property market and could see the property market stall.

My personal prediction?  Let me make it clear, I don't have a crystal ball, so this is just a guess, the same as any other person can make a guess.

• I feel that prices are going up too quickly in Auckland, Hamilton and Tauranga, and that this growth is unsustainable.
• Following the LVR changes, I feel other changes must happen.
• From a Hamilton perspective, we don’t have the same population growth and demand as Auckland.  I’m also very worried that we are reliant on Auckland, and any changes decided to slow Auckland could have major implications on Hamilton.
• If interest rates go up, many people won’t be able to sustain the mortgages they have taken out.

From this, my personal prediction is that the Hamilton and Tauranga boom will peak in around 12 months, so approximately November 2016.  It will be interesting to review in a year to see how close I am!

The Auckland market could be quite different.  There is a large shortage of houses, as well as huge population growth.  So I believe the Auckland market must slow at some point as it has been booming for a number of years.  However, once it slows, it is still likely to keep increasing, just at a slower rate.

I hope you have found this article useful.  Keep an eye out for a further article coming up before Christmas that will suggest some strategies you could put in place around this, depending on your circumstances.


Kind regards
Ross Barnett 

When it goes bad...

3 November 2015

When it goes bad

We all invest in property and business hoping that it will all go well, that the business will make good cash flow, and that properties will make good cash flow/equity gains. But, unfortunately, sometimes it does go wrong. Here are 5 ideas or provisions that can be put in place to improve your position.

1. General Security Agreement (GSA)

These are more important for business or property trading. If you are going to advance funds to a business or property trading entity, then you should put in place a formal loan document through a lawyer and a GSA. This helps the loan rank higher than other creditors or the IRD. So, if it all goes bad, then you should get your money back before these other parties.

Generally, the bank will have property as security and personal guarantees, so they will get their money first. Thus, a GSA does not improve your position in relation to the bank.

Example:

Joe Bloggs loans $100,000 to Awesome Property Trading Ltd, and with help from his lawyer, has a full loan agreement and GSA.
Awesome Property Trading Ltd (APT) buys a trading property for $300,000, with a bank loan of $200,000.
APT gets a GST refund of $39,000 approximately.
APT spends $80,000 renovating the property, by using the GST refund and owing suppliers $41,000.

Unfortunately, the property market crashes. Now the property is only worth $280,000 (IT CAN HAPPEN!)

Property is sold and bank is paid its $200,000. Leaving proceeds of $80,000.
GST is due on sale of $36,000 approximately.
Creditors are owed $41,000.
Joe Bloggs is owed $100,000.

Because Joe has a GSA in place, his debt has priority ahead of the others, and Joe would receive the $80,000.

BUT IF NO GSA WAS IN PLACE:
• IRD would get their $36,000 first as GST is a higher priority debt.
• Then the creditors and Joe would be entitled to the remaining $44,000 on a pro rata basis. So, they would get 31 cents in the dollar. This means Joe would only get $31,000 back.
Overall, if you are looking at lending a business or property trading equity money (whether yours or just as an investor), I recommend you discuss this with your lawyer!

2. Separate Banks

Using multiple banks is a common way of reducing risk. If you have all your assets and properties with one bank, then they have a high degree of control over you. If things go wrong, then they could force you to quickly sell properties or assets that might not be in your best interest overall.

By having multiple banks, you can often sell some assets, and maybe, in a worst case scenario, have to sell all properties with one bank.

3. Limited Guarantee on Personal Home

If you are using your personal home as security to buy a business or further rentals, then I suggest limiting the guarantee or security the bank has over it.

For Example:
• You have a debt free house worth $500,000.
• You are buying an Auckland rental for $600,000 and require $180,000 deposit.
• If given the opportunity, the bank will take full security of the rental and your personal house.
• BUT, you could limit the guarantee or security over your personal home to $260,000 approximately. 70% of this is the $180,000 deposit you need.
In a worst case scenario, the bank then only have limited security over your personal house, so could only demand that amount is repaid.

NOTE: The bank has most likely also got a personal guarantee, so you might be forced to repay the loan anyway!

4. Separate Bank for Personal Home and Separate Entity

Carrying on from Point (3), if you can separate the two banks, that can give you greater protection.

If personal property is put into a Trust, and borrows the $180,000 deposit from ANZ, secured over personal home (now Trust property):
Then for rental, $420,000 is borrowed from Westpac with personal guarantees.

If the rental somehow goes all wrong, and Westpac demands the loan repaid:
Say the property is only sold for $300,000. Westpac will then chase the individuals for the $120,000 remaining, but will have no claim over the Trust or the Trust property. So the individuals could go bankrupt. The Trust would still be stuck with the $180,000 loan it has borrowed from ANZ, but nothing futher.

Long term, it is a good idea to separate your personal home to a different bank, and a Trust can be a good ownership structure to help protect your assets. BUT, you do need to think through the costs and hassles, and whether you would just pay the shortfall anyway, rather than going bankrupt?

5. Avoid Linking Entities

Try to avoid any risky entity lending money to other entities. Otherwise, if the risky entity is sued or gets into financial difficulty, this could link in the long term holds and they could be forced to repay loans.

For example, if you operate a business or property trading activity that makes good profit. You might lend money from this entity to your long term hold rentals. Say $100,000 as per the example below:

A better approach would be to funnel profits back to the owners (Trust in diagram below), then for the Trust to lend the money to the Rental entity. This way the business and the rentals are not linked. If the business goes bust, then there is no effect on the rentals.

I would recommend getting advice on the best way to funnel profits back to the owners, and also on the overall structure that works best in your particular circumstances.

I hope this has given you some extra information to think about.

Kind regards
Ross Barnett
Branch Manager
Coombe Smith Chartered Accountants