The housing shortage is a perennial issue, particularly in metropolitan areas such as Munich, Berlin, and Hamburg. To create new housing, lawmakers are also attempting to provide tax incentives, such as the special depreciation allowance for new rental housing under Section 7b of the Income Tax Act (EStG). This was recently the subject of a dispute before the Federal Fiscal Court (BFH).
Ruling of the Federal Fiscal Court
In the case at hand, the plaintiff owned a single-family home that was being rented out and was in need of renovation. For financial reasons, she had the home demolished in June 2020. Subsequently, the property owner had a new single-family home built on the lot by the end of 2020, which has since been rented out for residential purposes.
In 2020, the plaintiff claimed as tax-deductible income-related expenses not only the regular straight-line depreciation of 2% of the building’s value per year at that time (Section 7(4) of the Income Tax Act (EStG)) but also the special depreciation for new rental housing of 5% of the building’s value per year—limited to the first four years following acquisition— (Section 7b of the German Income Tax Act (EStG)). However, the tax office rejected the claim for the special depreciation deduction during the initial assessment. The tax office justified this decision by stating that, as a result of the demolition and new construction, the plaintiff had not created new living space but had merely replaced existing living space. An appeal and a lawsuit in the first instance before the Cologne Fiscal Court were unsuccessful.
In its recent ruling, the Federal Fiscal Court upheld the position of the tax office and the Cologne tax judges and dismissed the property owner’s appeal. The court held that there was no entitlement to a special depreciation allowance under Section 7b of the Income Tax Act (EStG), since no additional living space was created; rather, existing living space was merely replaced by newly constructed apartments.
The regulations governing special depreciation allow for tax benefits only for construction projects that result in “new, previously nonexistent” housing units. What matters is an actual increase in the housing stock, since the purpose of the regulation is to promote the construction of additional new housing as part of the so-called “Housing Initiative.” Mere replacement and/or modernization measures are not covered and therefore do not align with the intent of the legislature.
A new construction following a demolition is eligible for preferential treatment only if the demolition and new construction are not part of a unified plan, there is no substantive or temporal connection between them, and additional new housing is being built. This is conceivable if the loss of the dwelling is permanent. In this case, however, there was a clear overall plan, since the building permit application for the new single-family home had already been submitted before the demolition. The connection to the existing housing stock was therefore clearly established.
As a result of this decision, real estate investors are strongly advised to ensure, when purchasing rental properties advertised as eligible for special depreciation, that the seller or developer provides a contractual assurance—in the notarial deed—regarding the abstract applicability of the special tax depreciation allowances for new rental housing.
In particular, real estate investors should ensure that the following points are legally documented in the notarial contract:
- Notice of construction or building permit application filed within the eligibility periods specified in Section 7b of the Income Tax Act (EStG)
- Whether the building notice or building permit application constitutes a new application rather than an amendment to a previous building permit application filed outside the eligible funding periods
- Completion and Transfer of Ownership, Use, and Liabilities Within a Calendar Year
- Vertragsgegenständliche Mietwohnung als Mietwohnneubau im Sinne von § 7b EStG
- The rental apartment that is the subject of the contract as a newly constructed rental apartment within the meaning of § 7b of the Income Tax Act (EStG)
- Certification of the “Efficiency House 40 with Sustainability Class (EH40NH)” energy standard with the “Sustainable Building Quality Seal” (“QNG”) by a QNG-accredited certification body
- Provision of all legally required documentation within 12 months of handover (QNG certificate, floor area calculation, determination of the maximum construction cost limit)
In the event of a breach of the above contractual obligations by the seller, liability for damages in favor of the real estate investor could be considered, to the extent that the special depreciation allowances cannot be claimed as a result of a breach of duty by the seller or developer.
Despite the Federal Fiscal Court’s clear stance, the legal issue has not been conclusively resolved in all respects; there remains room for interpretation and unresolved legal questions.
Among other things, it remains unclear how to handle cases in which an old single-family home is replaced by a building with two or more residential units. It is therefore also unclear whether at least the newly created second apartment is considered a “new, previously nonexistent” apartment and is thus eligible for tax benefits under Section 7b of the Income Tax Act (EStG), or whether a comparison of floor areas must be made. This could be particularly problematic when one residential unit is converted into two residential units, but the combined floor area of these two units is the same as that of the previously existing unit. This raises the question of which criteria should be applied to classify the “increased housing stock” as new rental housing. Should the determination be based on the number of residential units, the living area, or structural added value? Or is a combination of all these aspects relevant?
Conclusion
With its ruling, the Federal Fiscal Court is currently increasing the degree of legal certainty surrounding Section 7b of the Income Tax Act (EStG) and distinguishing between replacement construction and expansion of existing property; at the same time, however, it raises new possibilities for interpretation that require clarification by the legislature or a statement from the tax authorities in order to provide certainty for tax planning regarding investments.
