Compensation payments made to tenants as immediately deductible expenses
The BFH has accepted immediate deductibility
According to the BFH ruling of 20.9.2022 (case reference: IX R 29/21), financial settlements are fully deductible in the year in which they were paid if the aim is to refurbish the property once the tenant has moved out. Admittedly, obtaining a vacant property by paying a financial settlement will enable or facilitate the refurbishment works. However, in the opinion of the BFH, the financial settlements do not constitute acquisition-related production costs for the property under Section 6(1) no. 1a of the Income Tax Act (Einkommenssteuergesetz, EStG) that would have to be depreciated on a pro rata basis.
Subsequent production costs
Depreciation for a let residential property is included in the deductible costs for income from letting and leasing. The costs incurred for modernisation and maintenance (refurbishment) within a period of three years after the acquisition of the property would increase the assessment base for depreciation if a defined limit is exceeded. Such refurbishment expenses cannot be deducted immediately as costs related to letting and leasing but, instead, they constitute subsequent production costs and have to be depreciated over the useful life of the property.
These expenses include any and all building measures that are carried out at the time of the acquisition and through which defects and damage that are affecting the property are eliminated or through which the property is modernised. By contrast, the costs related to annually incurred maintenance expenditure do not constitute any production costs and they are thus immediately deductible.
Building measures - Narrow definition
According to the BFH, only building measures in the narrow sense can result in the recognition of subsequent production costs. This includes costs that would generally be deemed to be maintenance expenses such as, for example, the repair or renovation of existing sanitary, electrical and heating systems, floor coverings, windows and roof coverings. If certain expenses are merely materially related to the refurbishment and represent measures carried out at the same time then this alone would not be sufficient. In the above-mentioned ruling, the BFH quoted the preamble to the provision on subsequent production costs according to which
- “Repair and Modernisation Expenditure” [Reparatur und Modernisierungsaufwendungen] (Bundestag printed matter 15/1562 p. 24),
- “Costs for Maintenance and Modernisation” [Aufwendungen für die Instandsetzung und Modernisierung] or
- “Costs for Maintenance Works” [Aufwendungen für die Instandsetzung und Modernisierung] (Bundestag printed matter 15/1562 p. 32)
are supposed to be regulated. According to the BFH, costs that do not constitute a portion of those for maintenance and modernisation measures have to, in any case, be subjected to a separate tax law evaluation.
Financial settlements for tenants do not constitute maintenance/ modernisation measures.
The BFH does not consider financial settlements for tenants to be maintenance or modernisation measures within the meaning of Section 6b(1) no. 1a EStG. They are not included under building measures. Measures for cancelling an existing tenancy do not form part of the maintenance and modernisation of the substance of a building. Admittedly, the costs of demolishing an existing building on a property that was acquired for the purpose of redevelopment do indeed constitute the production costs of a new construction within the meaning of Section 6(1) no. 1 EStG if the new building is constructed on the site of the building that was demolished and, therefore, the demolition of the old building was a requirement for the construction of the new asset. Nevertheless, here, the use of the term production costs should be understood in a wider context. It is sufficient if the expenditure is made with the aim of production. By contrast, the presumption of subsequent production costs implies that the expenses are incurred “for maintenance and modernisation measures”. Furthermore, the BFH also pointed out that while the rule on acquisition-related production costs was based on the assumption that a lower purchase price had been calculated in view of the necessary maintenance expenditure so that, from an economic perspective, the cost of rectifying this forms part of the purchase price. Although this applies only precisely to building measures and not however to financial settlements for tenants.
Outcome: According to the BFH, financial settlements for tenants or compensation payments would not be reflected in a permanent increase in the value of a building so that the buyer of a property would normally have no reason to remunerate the vendor via a higher purchase price.