Insurance Proceeds and damaged buildings

By Tania Reid, Associate

Insurance proceeds

Insurance proceeds should only be taxed if the amount insured would have been. So insurance proceeds that recover lost profits such as rents are taxed, as the income would have been if earned from tenants. Any insurance proceeds for the loss of a building held as a capital asset should not be taxed, because they replace a capital amount. Another telltale indicator is if the premiums have been tax deductible, then it is likely any payout could be taxable.

Tax issues can still arise to recover past deductions, such as depreciation, if you actually make a gain in respect of your building. That past expenditure or loss can be recovered and brought back as income in certain circumstances, dealt with below, and will likely arise where buildings are insured for full replacement value.

Also, don’t forget the GST consequences. Insurance proceeds that relate to a loss incurred in carrying on your taxable activity are subject to GST. So take a close look at your insurance contract, as ideally the amount of the loss should be paid to you plus any GST.

However the liability falls on you as the recipient of the insurance payment, not your insurer, to return the GST to the IRD. Of course, you can claim this GST back on expenses incurred in replacing or repairing the insured building, in the usual way. But you will have to carry that GST cost in the meantime, unless it was also paid to you by your insurer.

Depreciation recovery income

While insurance recoveries for capital assets are not generally taxable, any past depreciation deductions you may have claimed from the cost of an asset can be clawed back and taxed. Depreciation recovery income arises when an asset is disposed of for more than its depreciated or tax book value (tax value). The amount of depreciation recovery income is the gain on disposal, up to the amount of depreciation that has been claimed. This tax consequence reflects that the value of your building has not in fact depreciated, if you were able to dispose of it at a gain.

What you may not realise, is that certain events -- irreparable damage, statutory acquisition or change of use -- which remove an asset from being able to earn income, also trigger this tax liability. In particular, where a building is irreparably damaged, the insurance proceeds received are treated as the disposal proceeds, for depreciation purposes. So if the amount of insurance you receive for a damaged building is more than its depreciated value, then you will have an amount of taxable income.

Because insurance proceeds are often calculated on the cost of replacing the building, having to meet a tax liability out of your insurance proceeds could leave you out of pocket when it comes time to meet the costs of replacement. The good news is that the government has recognised that the timing of this tax liability may not be appropriate and has offered some solutions. We look at the alternative scenarios below.

Building insured for replacement: Electing rollover relief

This option is available where your building was insured but rendered useless for deriving income and is demolished or abandoned for later demolition as a result of damage to the building itself or its neighbourhood from the Canterbury earthquake on 4 September 2010 or any aftershock.

You may choose to defer the depreciation recovered on an insured building, by rolling it over into the tax value of the replacement building. That way, it won’t be until the replaced building is disposed of that any recovery of that depreciation arises, and then only if that building is disposed of for more than its tax value.

The extent of rollover relief will depend on the degree to which the affected assets are replaced. It also takes into account any loss you may have had on underinsured buildings, so you need to have net depreciation recovered across all affected buildings.

There are a few conditions to qualify for this relief. The replacement building must be acquired and ready to rent by the end of your 2015/16 tax year and be located in greater Christchurch (districts covered by the Christchurch City, Selwyn or Waimakariri District Councils). So if you had hoped to invest your insurance proceeds elsewhere in the meantime, it may come at a tax cost, leaving you less to reinvest.

You must file a detailed election by the date you file your return for the year that the depreciation recovery would have arisen, or 31 January 2012 at the latest, and again in subsequent years. As detailed below, depreciation recovery on insured assets now arises in the year in which the insurance proceeds are ‘reasonably able to be estimated’.

We note that if you held your building on revenue account but intend to replace it, there is also a form of rollover relief now provided, to defer the tax consequences.

Building underinsured or not replaced: Paying the tax on depreciation recovered

If you don’t replace or elect rollover relief on your building, another timing issue arises - the depreciation recovery income from the building’s deemed disposal occurs in the year the building was irreparably damaged. But it may not be until some years later that the amount of the insurance proceeds can be finalised and paid to you by your insurer, so it may be impossible to correctly calculate the depreciation recovery income.

There has now been a law change to treat the time of disposal as the year in which the insurance proceeds can be reasonably estimated. This also applies to insurance proceeds for business interruption or impairment of business activities.

Claiming a loss

If your building was not insured, or your insurance proceeds are less than your building’s tax value, you could have a loss on disposing of your building; a possibility where insurance proceeds are based on an indemnity value. While a tax loss on disposal of a building is not generally allowed, there is an exception where it was irreparably damaged by events beyond your control, such as a natural disaster.

The depreciation rules have been amended to allow a loss on buildings that must be demolished as a result of such an event. In particular where a natural event caused damage to the building or its neighbourhood, rendering the building useless for deriving income and it has been demolished or abandoned for demolition.

This means you can still claim a tax loss if your building is required to be demolished to enable the demolition of a neighbouring building or to repair the land underneath, even if the building itself survived relatively unscathed. Your demolition costs should also be deductible in this situation, following changes introduced last year.

Making repairs

Finally, if your building is damaged, but does not have to be demolished, you are not deemed to have disposed of it for depreciation purposes. But you will still need to take care when spending your insurance proceeds. If you have insurance proceeds left over after repairing your building, you must deduct this from the building’s depreciated value. If these proceeds are greater than the building’s depreciated value, then taxable income my arise from the recovered depreciation.

A somewhat nasty “sleeping dragon” for those building owners whose repairs end up costing them considerably less than they had negotiated with their insurer. We understand that this section may be looked at further by officials in the coming months.

There may also be situations which are not directly covered by the current tax relief. The sale of damaged buildings and assignment of insurance policies may give rise to tax issues. Harsh outcomes affecting a significant number of taxpayers may be of interest to officials in the coming months. So if you have any questions or concerns about these or other tax matters, please contact a member of our tax team.

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