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Edited version of private ruling
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Ruling
Subject: Rental property legal expenses
Question
Can you claim the expenses you incurred for legal fees and the specialist building inspectors report as deductions?
Answer: No
Relevant facts
You own an income producing rental property in a block of strata titled units. You incurred legal fees and costs for a building inspection in an attempt to have a long standing water leak into the property repaired. You are of the understanding that the source of the water is from a part of the building structure other than your own unit, and this has been verified by the building inspection report.
Reasons for decision
Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or related to the earning of exempt income.
In determining whether a deduction is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; 8ATD 190; 3AITR 436 per Dixon J). The nature or character of legal expenses follows the advantage which is sought to be gained by incurring the expenses.
Where legal expenses arise as a consequence of the day to day activities of an income earning pursuit, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; ATD 87; (1938) 1 AITR 403).
The Courts have developed various tests for determining whether expenses are of a revenue nature or a capital nature. The most important test was derived from the comments made by Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87 (Sun Newspapers case).
In the Sun Newspapers Case, at CLR page 359, Dixon J observed that:
The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning or profit and the process by which such an organisation operates to obtain regular returns……
On the basis of this test, an expense is considered to be of a capital nature if it relates to the profit yielding subject and to be of a revenue nature if it relates to the process of operating the profit yielding subject.
In your case, you incurred legal expenses in attempts to have the faults in the strata titled property rectified. The advantages sought relate to the property itself and are of a capital nature. As the advantages you sought to gain by incurring the legal expenses are of a capital nature, the legal expenses are also of a capital nature.
As the legal expenses are of a capital nature, you cannot claim a deduction for these expenses under section 8-1 of the ITAA 1997.
As part of the legal advice you were advised to have a building inspection of the area above your unit undertaken. On examination of the balcony floor and other areas of the unit directly above your unit there was no physical evidence of water migration or failed waterproofing. The inspection did find that some external wall cracks in the building are an avenue for water to penetrate into the internals of the building, and should be addressed soon.
The inspection costs are costs which were incurred in an attempt to have the owner of the unit above you or the body corporate take responsibility for effecting remedial work for the water problem which affects your unit.
It is considered that the costs of the inspection are also capital in nature and not deductible.
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