The question is, can you write off this deposit as a bad debt? The short answer is no.
Why is this? When you buy in such a scenario, you have bought on what is called "capital account". That means that you are not buying and selling houses and making money on the profits, which is called buying on "revenue account." Rather, you have spent money to acquire or improve a long-term asset such as equipment or buildings. When you sell the asset, at present there will be no tax on the capital gain. Likewise, if you make a loss when you sell, you can't claim that loss. And in a similar way, if your calculated risk ends up in losing your deposit, that too is not claimable.
In other words, could you argue that the deposit is not a deposit? Rather, that it is payment for a set of services including designs, council fees, etc, meaning that this is not an asset?
A: No. This doesn't really change things. However it may depend on what your contract states. If your contract indicates that the monies given to the builder are a loan to be repaid (irrespective of their nature) then it would possibly fall under the definition of a bad debt. It would be best to check the wording of your contract with your lawyer. If it reveals that this is the case, then the possibility of claiming this can be examined. However, we stress that this is very very low.
Q: The house is not an asset at this stage, so shouldn't the deposit be able to be recorded in the Profit & Loss as an expense?
A: No. Again one comes back to the purpose. The house was, in this scenario, part of a capital account purchase, not a revenue account purchase. Therefore, the lost deposit is not deductible.
Q: Any company that I have worked for where the supplier has gone under has been able to capture the loss associated in the Profit & Loss. What's the difference here?
A: No. The sort of situation where a supplier has gone under is a revenue situation. That is, supplies are bought to on-sell. A supplier is paid for goods that it doesn't deliver. Therefore, the undelivered goods for on-sale can be treated as a bad debt, provided that matters are handled correctly.
Q: I thought that a debt can be written off as "bad" when a reasonably prudent commercial person would conclude that there is no reasonable likelihood that the debt will be paid. Isn't that what the law says?
A: Yes (see here), but again that is not the situation here. That only applies in a "revenue" scenario, and only where the other requirements are met.
Q: What about legal expenses? Are they deductible?
A: Yes and No. If the legal action is taken to recover items such as interest reimbursements not paid (which would have been declared as income, i.e. as revenue) then the legal expenses are fully deductible if they come to less than $10,000 in one financial year. If more than $10,000 they are capitalised and depreciated.
However, where legal action is taken to recover deposits not paid on land/buildings ie items of a capital nature and this cost exceeds $10,000 in the financial year, then the portion of legal costs related to this would not be deductible.
The converse is also true: even if your legal costs are a mix of costs related to capital items and revenue items, the entire amount can be claimed so long as it doesn't exceed $10,000 in one financial year.
Q: So does that mean that nothing is deductible then?
A: No. The usual expenses (see here for a sample list) are still deductible.
- Some contracts with developers include a provision whereby the developer must reimburse interest costs incurred on the building during the build costs. At times these are paid by way of a credit from the developer to the client’s bank account, and other times they are deducted from a progress payment to the developer. Could these be viewed as a loan of sorts to the developer (seeing as they are legally obliged to reimburse the client) and therefore qualify as bad debts?
- Some contracts also specify that the developer will pay a rental top-up of $50/week or similar for the first 12 months. Could this be viewed in the same way and therefore be written off as a bad debt?
- Some contracts specify that the deposit paid to the developer is for designs, engineering and council consent. As being able to build a house is by no means guaranteed due to the fact that consent may not be obtainable, does this change the deductibility of the costs in the above-mentioned scenario?
- In view of significant rises in the Auckland property market, could the client decide by way of company resolution (most have purchased the investment property using an LTC) that the project shall now be sold at some stage, with the intention of making a profit which will be subject to capital gains tax, ie, that it shall be viewed as a “revenue” investment and not a “capital” investment? As an incidental effect of this decision, then in the above scenario would this mean that deposits and progress payments could therefore be written off as bad debts? Or could this run the risk of being viewed as tax avoidance?