New Zealand has taken a battering in recent years from major disasters including earthquakes, fires, cyclones and floods. These have caused business disruptions, devastated lands, and damaged our capital’s infrastructure and homes. Where insurance is received, a question often asked is how these receipts should be treated for tax purposes.
Whether insurance proceeds are taxable will depend on what the proceeds are received for. If proceeds are for items of a revenue nature, such as loss of profits, rents, or reimbursement of business expenses, the proceeds will generally be taxable. Receipts for income protection will also be taxable because they are typically based on loss of earnings and especially if you have been claiming a tax deduction for the premiums.
Insurance proceeds for capital items such as residential properties and loss of land, will generally not be taxable, unless you are in the business of dealing in property.
Depreciable assets – compensation received for depreciable assets is treated as though the asset has been sold to the insurance company for the amount of the compensation received. If the compensation is less than the asset’s tax book value (TBV), a loss on disposal can be claimed (for assets other than a building). However, where it is more, tax will need to be paid on any gain made above TBV (i.e. depreciation recovery income is recognised). Any gain above the asset’s original cost is a tax free capital gain.
The Canterbury Earthquake – specific provisions were enacted for buildings that were damaged in the Canterbury earthquake. As a starting point, proceeds will always be taxable to the extent of the cost of repairs. This results in a net nil position for income tax purposes. Where proceeds exceed the cost of repairs (“the excess”), the tax treatment will depend on whether the property is deemed “repairable” or “irreparably damaged”.
For “repairable” property, the excess is deducted from the property’s TBV. If the adjusted TBV is reduced below zero, the negative TBV would ordinarily be taxable depreciable recovery income. This is however, limited to the lesser of the negative TBV and the actual depreciation claimed to date and is taxable in the income year in which the proceeds are applied to reduce the TBV. Any remaining amount will be treated as a capital gain. Conversely, if the excess does not cause the adjusted TBV to become negative, the depreciation recovery income will be deferred until the property is later sold.
A property will be “irreparably damaged” if it has been rendered useless for deriving income and is demolished or abandoned for later demolition. This should be agreed with the insurer and documented in the settlement agreement. The property is treated as sold for the amount of the insurance proceeds, and re-acquired for nil consideration. Any depreciation recovery income can be deferred and offset against a replacement asset that is purchased by the 2018/2019 income tax year. The remainder will be a capital gain.
The proceeds of a future sale will be all capital gain, assuming no other taxing provision applies as the property’s tax base is nil for depreciation purposes.