Throughout the leaky building crisis there has been a lack of certainty around whether the remediation of leaky buildings is deductible repairs or non-deductible capital works.

Precedent cases are typically very old law, dating to cases around remediation of railways and gas pipe systems.

The lack of a modern case is probably due to the financial devastation of going through a leaky building issue and finding oneself without the financial or personal resources to then take on the IRD in another fight.

However, we have a recent decision in the case of E & G Lawrence v CIR that offers some clarity on the question, but unfortunately does not end with a decision that will assist investors facing extensive remediations.

The Lawrences purchased a freestanding fibrolite-clad house in Tauranga in 2014 for $350,000 with a GV of $305,000. They commissioned a non-invasive visual building inspection which concluded the house was well constructed and in good condition for its age.

Kitchen Leaks

The trouble began in 2017 with reports of leaks in the kitchen. These were attributed to internal guttering and poor roof design. Guttering was replaced but the leaks returned. Focus turned to the need to redesign the roof, guttering and lack of window flashings.

The cladding also had no cavity and was considered problematic. The Lawrences opted to do more, rather than less, and began work to redesign the roof and guttering and reclad the building. This required consents. Inspections as part of the consenting process then found non-compliant stud work, inadequate drainage and a rotting deck that needed replacement.

To replace the deck, a retaining wall also needed a re-design and rebuild. The more layers that were peeled from the onion, the more problems were found.

The Lawrences claimed $61,140 of costs in 2018 and $303,654 in 2019. CCC was ultimately granted for the works and a valuation for the bank in 2018 valued the property at $700,000.

The IRD reviewed the claims and sought to deny them, citing the capital limitation in section DA2(1) that denies deduction where works are capital in nature. There was no dispute over the general permission to deduct expenditure in section DA 1 (1) as the property had always been a rental for the Lawrences, so retained a nexus with income.

Remedy In Courts

The legal process focused on the precedent cases and centred on; firstly, identifying the asset being worked on, in this case clearly the building. The second question was identifying the nature and extent of work undertaken.

This comprises three tests:

1. Whether work resulted in the reconstruction, replacement or renewal of substantially the whole of the asset
2. Whether works changed the character of the asset
3. Whether work formed a single project of work.

In court, both parties presented expert witnesses. The judge favoured evidence presented by the IRD’s building expert who testified that the redesign of the roof, replacement of joinery and guttering, and the recladding did substantially reconstruct the house and also altered its character and extended its life.

The fact the Lawrences had no knowledge of the defects when they purchased the property and the fact that much of the work they were forced to undertake was required as part of the consenting process for the remediation did not assist them to argue the work was deductible repairs.

Ultimately, the judge found for the IRD and handed down a judgment that the works were capital in nature and non-deductible. In summary he also stated that the decision he came to was “very easy ... it was a clear-cut case”.

‘Extent And Degree’

IRD reassessed the Lawrences’ tax returns and denied the deductions for the remediation they had claimed as repairs. Costs were awarded to the IRD.

This case reinforces the “extent and degree” arguments that IRD so frequently cite in cases involving remediation. This makes it harder for investors to establish that where extensive remediation is involved, the extent and degree of that work remains repairs to the building, rather than crossing over to become non-deductible capital works.

I’d like to acknowledge the Lawrences for having the tenacity to take a case and argue for their position despite the impact the need to remediate their investment must have had. We are at least clearer now on where the line in the sand lies on the vexed question of deductible repairs or non-deductible capital works.

Mark and his team specialise in advising on property-related transactions, valuation and restructure services, and tax planning. PKF Withers Tsang & Co Phone 09 376 8860, www.pfkwt.co.nz