Edited version of private ruling

Authorisation Number: 1011608582097

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Ruling

Subject: Rental property deductions

1. Are you entitled to claim a deduction for legal costs incurred in preparing a property development contract?

No.

2. Will the legal expenses form part of your cost base, for capital gains tax (CGT) purposes, when you sell your property?

No.

3. Are you entitled to claim an immediate deduction for costs incurred for restoration work carried out on your property as repairs?

No.

4. Are you entitled to claim a deduction for costs incurred for restoration work carried out on your property as capital works, at a rate of 2.5% over 40 years, where you continue to use it as an investment property?

Yes.

5. Are costs incurred for new carpets and curtains included in your capital works deduction?

No.

This ruling applies for the following period

Year ended 30 June 2007

Year ended 30 June 2010

The scheme commenced on

1 July 2006

Relevant facts

You own an investment property.

You entered into a contractual arrangement with a builder to have your investment property demolished and townhouses built on the land.

The arrangement was that the builder would own a number of the townhouses and the other one would be yours in return for your land.

The builder had begun to demolish your property when he experienced financial difficulties and could not continue and then the development approval lapsed.

You incurred legal expenses drawing up the contract with the builder.

The property remained untouched for a few months, during which vandals entered the property and did substantial damage, breaking windows and internal walls.

You received a quote at the time from a builder to repair the damage but could not afford to have the work done.

You had cancelled your property insurance due to the development and did not report the vandalism to the police.

The property remained empty and un-repaired for over two years while you attempted to sell the property.

After there were no offers to buy the property, you carried out repairs on the property yourself, at a cost of approximately $20,000, including new carpets, curtains and fly screens.

The property is now tenanted and producing rental income.

Reasons for decision

Legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a person to claim a loss or outgoing that is incurred in gaining or producing assessable income so long as the loss or outgoing is not of a capital, private or domestic nature.

Expenditure made in order to preserve the profit-yielding structure is generally considered to be of a capital nature and therefore is not deductible, whereas working or operating expenses are considered of a revenue nature and hence deductible.

The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403:

· the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or

· the nature of the advantage has lasting and enduring benefit, or

· the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

In Broken Hill Theatres Pty Ltd v. Federal Commissioner of Taxation (1952) 85 CLR 423; 9 ATD 423 the High Court applied the above tests to find that legal expenses incurred by a motion picture proprietor in successfully resisting an application by a would-be competitor to obtain a license permitting the showing of motion pictures in the same area were not deductible expenses on revenue account.

In your case, you entered into an agreement with a builder to demolish your existing investment property and build townhouses on your land and, in return, you would receive one of the townhouses. The legal costs you incurred to prepare the contract with the builder were essentially for the replacement of a profit yielding structure and, therefore, capital in nature. As such, your legal expenses are deemed to be capital in nature. Since the legal expenses are of a capital nature they are not deductible under section 8-1 of the ITAA 1997.

Cost Base

CGT is the tax you pay on any capital gain or capital loss you make. A capital gain or capital loss may arise if a CGT event happens to a CGT asset that you own (section 102-20 of the ITAA 1997).

The most common CGT event is CGT event A1, the disposal of a CGT asset (section 104-10 of the ITAA 1997).

For most CGT events, the cost base of a CGT asset is important in working out if you have made a capital gain. For working out the amount of a capital loss for these events, the reduced cost base of a CGT asset is relevant.

The cost base of a CGT asset consists of five elements (section 110-25 of the ITAA 1997).

The first element is made up of the money paid or required to be paid to acquire the CGT asset (subsection 110-25(2) of the ITAA 1997). The costs you incurred in preparing a contract for the failed redevelopment of your property do not fall under acquisition costs.

The second element will include incidental costs of acquiring the asset, or costs in relation to the CGT event. Examples are agent's commission, advertising to find a seller or buyer, fees paid to an accountant (subsection 110-25(3) of the ITAA 1997). The costs you incurred in preparing a contract for the failed redevelopment of your property do not fall under incidental costs.

The third element consists of non-capital costs incurred in connection with their ownership of a CGT asset. Examples are interest, rates, repairs and insurance premiums. You can include non capital costs of ownership only in the cost base of assets acquired after 21 August 1991 (subsection 110-25(4) of the ITAA 1997). The costs you incurred in preparing a contract for the failed redevelopment of your property do not fall under non-capital costs.

The fourth element of the cost base includes capital expenditure you incurred to increase an assets value, such as the construction of a veranda. The expenditure must however be reflected in the state or nature of the asset at the time of the CGT event (subsection 110-25(5) of the ITAA 1997). The costs you incurred in preparing a contract for the failed redevelopment of your property do not fall under capital expenditure because it must be reflected in the state or nature of your investment property when a CGT event occurs to the property (that is, when you sell the property).

The fifth element includes capital expenditure you incur to preserve or defend their title or rights to the asset (subsection 110-25(6) of the ITAA 1997). The costs you incurred in preparing a contract for the failed redevelopment of your property do not fall under preserving or defending the title of your investment property.

As these expenses do not fall under any of the five elements of the cost base, the legal expenses will not form part of the cost base of the property for CGT purposes when you sell the property.

Restoration of property

Section 25-10 of the ITAA 97 allows a deduction for the cost of repairs to premises used for income producing purposes. However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs where the expenditure is of a capital nature.

Taxation Ruling TR 97/23 discusses the circumstances in which expenditure incurred for repairs may or may not be an allowable deduction under section 25-10 of the ITAA 1997.

The word 'repair' is not defined within the taxation legislation. Accordingly, it takes its ordinary meaning. Works can fairly be described as 'repairs' if they are done to make good damage or deterioration that has occurred by ordinary wear and tear, by accidental or deliberate damage or by the operation of natural causes during the time the property was held for an income producing purpose.

In your case, your property was partly demolished and vandalised during a period when you had ceased to hold it for an income producing purpose. You had initially entered into an agreement to have the property demolished and then attempted to sell the property. It was during this period that the property also sustained significant damage by vandals. The nexus between the damage done and the property's previous income producing purpose had been broken. Therefore, costs incurred for the restoration of the property more than two years later are not repairs for the purposes of section 25-10 of the ITAA 1997 and you are not entitled to an immediate deduction for these costs.

Capital works deduction

As the property is now being used for an income producing purpose, you are entitled to claim a deduction for some of these expenses as a capital works deduction under Division 43 of the ITAA 1997.

Section 43-25 of the ITAA 1997 provides the relevant rate allowed for your capital works deduction as 2.5% per annum over 40 years while the property continues to be used for an income producing purpose.

Taxation Ruling TR 97/25 discusses the entitlement and calculation of capital works deductions. In the case of capital works carried out by an owner, the deduction is calculated with regard to expenditure actually incurred. The value of the owner's contributions (such as labour and expertise and any notional profit element) do not form part of construction expenditure (at paragraph 20).

Section 43-30 of the ITAA 1997 states that no deduction is available until construction is completed.

In your case, you completed the restoration work on your property in mid 2010 and began to use the property for an income producing purpose shortly after. Therefore, your capital works deduction will begin in the 2010-11 income year.

Carpets and curtains

Construction expenditure for capital works does not include expenditure on plant. In relation to a rental property, plant includes carpets and curtains; therefore, costs incurred for these items are not included in your capital works construction expenditure. However, these items are considered depreciating assets and you will be entitled to claim a deduction equal to the decline in value of these items over their effective life.

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