Let battle for chattels begin

Q. I wonder if you are aware that Inland Revenue will accept property valuations showing a chattels value as high as one-third of the value of an investment property purchase, with the consequent depreciation of these "chattels" at a rate of 18 per cent.

"Chattels" include such things as electrical wiring, plumbing, partition walls (any wall not holding up the roof), the drive, letterbox, fencing and so on, in addition to the traditional chattels such as carpets, curtains and light fittings.

The depreciation of these "chattels" has a significant effect on the investor's tax and, for several years after purchase, can result in a refund from Inland Revenue.

The astute investor then appropriately attributes the sale price to the land, building and chattels in the sale-and-purchase agreement, escaping with no or minimal tax on recovered depreciation.

As a taxpayer I am astounded that IRD should have allowed this situation to arise. But as an owner of two investment properties, I am asking myself, why shouldn't I take advantage of this apparent laxity?

A. Perhaps because you don't want to run the risk of battling Inland Revenue.

You're not quite correct in saying that wiring, plumbing and so on are sometimes treated as chattels. But in some circumstances they can be categorised as "building fitout" assets, says an IRD spokesman.

Let's say you are running a business in a building you don't own - typically a commercial building - and you put in extra wiring, partitions and so on. You can depreciate those items as fitout assets.

But if you own the building - whether you're running a business or renting out a residential property - the IRD requires you to depreciate everything that is "permanently affixed to or wrought into" the building at the same rate as the building itself, 4 per cent a year.

"If you own a car and depreciate it, you don't depreciate the brake pads separately from the car," says the spokesman.

How does IRD define "permanently affixed etc"?

Well, carpet is not permanent, but lino is. "If you can't get it out without destroying something, it's part of the bigger asset."

The spokesman acknowledges, however, that some landlords are trying to claim the sort of deductions you write about.

"This trend is based on an argument that a residential property consists of a number of assets that may or may not depreciate at the same rate as the exterior walls and roof," he says.

The argument is strengthened by the fact that Inland Revenue has a list of depreciation rates for building fitouts.

"There are some differences of view out there. Some advisers have argued about what's said in our depreciation booklet.

"They believe we have somehow given a green light to this practice," says the spokesman.

"But we don't believe we have changed our view on this. If we audit someone and find they have claimed depreciation incorrectly, we take steps to correct the position, if necessary using the disputes process."

Because of all the disagreement, IRD's adjudication and rulings unit plans to issue new guidelines for IRD staff and taxpayers, probably within a few months.

You also bring up a separate issue: how the proceeds after you sell a rental property are divided among land, building and chattels. That, of course, affects how much of your claimed depreciation is clawed back.

Inland Revenue will expect you to use a similar division to the one used when you bought the property, says the spokesman.

If a taxpayer seems to be minimising any clawback, "the commissioner would look carefully at the situation, including any valuation the taxpayer seeks to rely upon, and, if necessary, would apply the anti-avoidance rules where a deliberate attempt was made to distort values".

A report from a registered valuer doesn't necessarily cover you. "We've had ongoing dialogue with a number of valuers," he says.

How likely is a landlord to be challenged about all this? Not surprisingly, the spokesman doesn't give any figures. "Anecdotally there are a lot of cases out there identified by investigators in the field. We're looking at it more often than we used to.

"If any of your readers are unsure of the correct depreciation treatment for their investment properties they should talk to Inland Revenue. We would be pleased to assist them."

It's up to you, then. Be richer and more worried, or not quite so rich and a better sleeper.

By the way:

* Not all chattels are depreciated at 18 per cent. The rate for residential rental chattels varies from 12 per cent for fitted furniture to 50 per cent for items such as bedding, cutlery and vacuum cleaners.

* You cannot claim depreciation for a drive. "It would be considered part of the land, and land is not a depreciable asset," says the spokesman. You can depreciate letterboxes at 7.5 per cent and fences at 9.5 per cent.

* * *

Q. I was disappointed to read two weeks ago that you advise declaring share profits if the shares were sold after being held for two years.

I have been trading for 18 years and have had, at times, intense discussions with Mr IRD. Off the record they are quite clear that they will treat shares held for two years or longer as investments, in all cases. For periods less than two years, they may consider them as trading profits.

The main point of contention is whether or not one has a business. Court cases over the last 10 years have almost universally been in favour of the individual.

Setting up a "superannuation portfolio" charter, such as reinvesting all dividends and profits and taking nothing out of the pot for at least five to 10 years, strengthens one's position.

I would certainly be conservative in my advice for mum and dad investors, but I don't think the question you answered was from such a person.

May I be impertinent and ask if you are a "trader" of two years or less yourself, and do you buy and sell for yourself, and what percentage of your investments are in shares? I do think this is relevant, as only those who do, know.

Nothing like a lively discussion.

A. Yes, you may be impertinent. The vast majority of my investments are in shares, via well-diversified share funds.

I'm not a trader. I've read too much research that shows that most traders do worse than those who buy and hold - partly because of transaction costs, which can include tax. Besides, I don't want to put the time into it.

So you're right, I don't have first-hand knowledge of this. I decided, therefore, to talk to a man who knows not just about his own investments but those of his firm's many clients.

Deloitte tax partner Greg Haddon was quoted in the Herald recently warning people who plan to buy in the upcoming Vector share float in the hope of selling soon after at a profit.

It's quite likely, he says, that Inland Revenue will check people who quickly drop off the Vector share register.

"The department might say, 'Why did you sell if you didn't buy for resale'?

"You would have to come up with a plausible reason, for example your son had an accident and you had to come up with some money unexpectedly," or your gain would be taxable.

The case of the correspondent two weeks ago is not so clear-cut, however.

Let me say, firstly, that I didn't write that everyone who has sold shares after two years should declare the profits.

What I said was: "If you are regularly selling shares you've owned for only a few years - and especially if you're selling to capitalise profits - you'd be hard-pressed to convince the IRD that you didn't buy 'with the dominant purpose of resale', which means your gains are taxable."

However, I might be guilty of leaping to conclusions from what the man said. If he genuinely buys shares for the dividends, but his broker occasionally talks him into selling, he doesn't need to declare the gains.

My answer "was a bit black and white", said Haddon.

The same, though, could be said for some of your statements. Haddon disagrees that the IRD sets a two-year cutoff.

He's aware of people who have paid tax on profits after selling shares held for more than two years, "if it's pretty clear they bought with the intention of sale".

"Each situation is unique. You also may get different interpretations from different officers in the department."

What about court cases? "The interesting thing is that, in the early '90s, there were a lot of share losses, and a number of individuals took cases to say they were dealers so they could claim the losses."

Since then, they have presumably had to declare their gains, "unless they could show a change in their operations. But it would be hard to argue."

Nor is Haddon convinced by your charter idea. He says if a charter merely records that you are taking profits but leaving the money "in the pot", those gains could still be taxable.