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Ruling

Subject: Assessability of cash settlement insurance payment for flood damage to a rental property

Questions

1. Is a cash payout under a building insurance cover for an investment property assessable for income tax purposes in the income year it was received, when no related deductible repair expenditure has occurred?

No.

2. Is there any assessable capital gain at the time you receive the cash settlement insurance payout as compensation for the damage to your rental property?

No. But the CGT cost base for the rental property will be reduced by the amount of the cash settlement.

3. Is a portion of the insurance payout you received to cover the cost of restoring your investment property, equivalent to the amount of deductible expenditure you incur in a year of income to repair the property, included in your assessable income?

Yes.

4. If the insurer's builder was to repair the rental property, will there be any assessable income to you?

No.

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You bought an investment property and the property has been tenanted. The property was flooded, resulting in severe damage to the inside of the house. The property is insured.

The builder engaged by the insurer has completed full costing for reconstruction. The external walls and frames of the house are safe however every internal wall and ceiling in the home must be replaced, this includes the bathroom and kitchen. Nothing inside the home will be retained. The builder has provided a quote to bring the property back to the original state. There is a list of all the separate items to be replaced but no break-up of costs.

Having been through one flood you are unsure whether you want to bring the property back to the original state and considering the major drop in property value, you are thinking about seeking a cash settlement from the insurer to reconstruct the house based on your terms.

Your intention with the cash payout is to carry out the work yourselves to save on labour costs. You have family and friends in various trades who can assist for free. Your only outlay will be for materials. The remaining part of the payout, you hope to put into the loan to offset against the reduced property value due to flooding.

Relevant legislative provisions

Income Tax Assessment Act 1997, Section 6-5

Income Tax Assessment Act 1997, Subdivision 20A

Income Tax Assessment Act 1997, Section 20-20

Income Tax Assessment Act 1997, Section 20-25

Income Tax Assessment Act 1997, Section 20-35

Income Tax Assessment Act 1997, Section 20-40

Income Tax Assessment Act 1997, Section 20-45

Income Tax Assessment Act 1997, Section 25-10

Income Tax Assessment Act 1997, Section 110-25

Income Tax Assessment Act 1997, Paragraph 110-45(3)

Reasons for decision

Summary

If a cash payout is received from the insurance company for the damages to the rental property, it is not considered to be ordinary income as it is a one-off payment of a capital nature.

If the payment is received, before any repairs are undertaken, the cost base for capital gains tax purposes will be reduced by the amount of the payment, as the recoupment does not form part of any element of the cost base.

When deductible expenditure is incurred on repairs, this will trigger the assessable recoupment rules in subdivision 20-A of the Income Tax Assessment Act 1997 (ITAA 1997) which will bring an equivalent portion of the insurance payment into your assessable income in that year. Because this amount is included in your assessable income it will now be included in the capital gains tax (CGT) cost base.

If the repair work was carried out by the builder and they are paid by the insurance company, there will be no amount included in your assessable income and there will be no change to the CGT cost base. You are not in the receipt of any payment and have not incurred any expenditure.

Detailed reasoning

An amount received as an insurance payment for damage to a rental property has to be considered under both the concepts of ordinary income (section 6-5) and statutory income (capital gains tax [Part 3] or assessable recoupment [section 20-20] of the ITAA 1997).

Ordinary income

Section 6-5 of the ITAA 1997 provides that your assessable income includes income according to ordinary concepts, which is called ordinary income. 

Ordinary income has generally been held to include three categories:

· income from rendering personal services

· income from property, and

· income from carrying on a business. 

Other characteristics of income that have evolved from case law include receipts that: 

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity. 

Taxation Ruling TR 95/35 provides that on a 'look-through' approach a compensation payment inherits the characteristics of the item for which the payment is made. Accordingly, it is necessary to establish what you are being compensated for in order to determine whether the payment will form part of your assessable income. For example, if the compensation is paid in respect of a capital asset or amount then it is regarded as a capital receipt and not ordinary income.

In your case, the insurance company will either pay a settlement amount for damages to your rental property from the floods or the repairs to your property will be carried out by a builder who will be paid this amount.

The payment does not fit into the three categories of ordinary income listed above. It is a one-off payment without an element of recurrence or regularity and does not possess any of the other characteristics of ordinary income listed.

In accordance with the guidance provided in TR 95/35, the 'look-through' approach provides that the payment relates to your rental property which is the capital asset that has suffered the damage/permanent reduction in value. Therefore, because the payment is made in relation to a capital asset it is inherently regarded as a capital receipt.

It follows that the compensation payment does not constitute ordinary income under section 6-5 of the ITAA 1997.

Capital Gains Tax

Taxation Ruling TR 95/35 sets out the capital gains tax consequences when a taxpayer receives a compensation payment. One of the receipt types it addresses is 'compensation for permanent damage to, or permanent reduction in the value of, the underlying asset'.

In applying the 'look through' approach to determine the underlying asset to which the payment relates, paragraph 6 states:

6. If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Paragraphs 7 and 8 discuss the consequences of the recoupment, and have direct application to the calculation of the cost base of an asset in terms of subsection 110-45(3) of the ITAA 1997, recouped expenditure. These paragraphs state:

7. Accordingly, the total acquisition costs of the post-CGT asset should be reduced … by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition costs (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount.

8. The adjustment of the total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred …

A compensation payment in these circumstances is considered a recoupment which directly reduces the cost base of the underlying asset. It is not a receipt in relation to the disposal of a separate CGT asset. It follows that a CGT event has not happened and there is no assessable capital gain in terms of Division 104 of the ITAA 1997.

Under subsection 110-45(3) of the ITAA 1997 expenditure does not form any part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income.

Example 6 from TR 95/35

Ken owns a rental property which he bought in May 1988 for $100,000. In July 1992 Dave, an employee of the Roads Authority (RA), was being trained in the use and operation of a steam roller. Dave, being a conscientious and diligent employee, decided to try out a few of his newly learned manoeuvres. Unfortunately, this took him past and through Ken's house. This resulted in severe damage to two of the front rooms of the house, and a partial collapse of the roof. Ken is not insured against the damage.

IN March 1993, Ken was awarded $50,000 in damages for his claim against RA for negligence (the amount awarded to Ken related solely to the damage incurred). In April 1993, he spent $50,000 in repairing the damage to his house.

Relevant Asset: The rental property

Acquired: May 1988

Cost base: $100,000 ($50,000 + $50,000)

Disposed of: Not yet disposed of by Ken

Consideration: $50,000

CGT consequences: There is no capital gain or loss at the time of the receipt of the compensation. At that time the total acquisition costs of the property were $100,000. This is reduced by the compensation, then later increased by any deductible expenditure on the property, that will include amounts of the settlement payment in your assessable income under the assessable recoupment rules.

You advise that the insurance company may make a cash settlement payment compensating you for the damages caused to your rental property by the flood before repairs are undertaken.

When applying the 'look through' approach provided for in TR 95/35 it becomes apparent that the underlying asset in your case is the rental property.

The facts of your case indicate that your property was damaged in the flood requiring a reconstruction of the full internal of the rental property. This damage would cause a permanent reduction in the value of the property.

As you are not disposing of the rental property at this time we consider that the compensation payment is to be made in respect of the permanent reduction in value of your property, and will represent a recoupment of part of the acquisition cost which will directly reduce the rental property's cost base in terms of subsection 110-45(3) of the ITAA 1997.

It follows that for the year in which the compensation amount is received, unless the rental property is sold, there will be no CGT event and no assessable capital gain in terms of Division 104 of the ITAA 1997.

In the event that you decide to dispose of your rental property in the future the effect of the recoupment will mean that your capital gain will be greater. Providing the relevant qualifying criteria are satisfied the discount capital gains provisions will be available to be applied to the whole gain at that time.

Assessable recoupment Subdivision 20-A

An amount is not an assessable recoupment to the extent that it is ordinary income, or it is statutory income because of a provision outside of Subdivision 20-A of the ITAA 1997. No part of the insurance payment has been included in your assessable income at the time of receipt. The effect of the capital gains tax legislation is to decrease your cost base, as discussed above.

An amount received by way of insurance is an assessable recoupment if it is paid to cover the cost of a deductible expense and the deduction can be claimed in the current year or in an earlier income year (subsection 20-20(2) of the ITAA 1997). [Current year means the income year for which you are working out your assessable income and deductions].

If you receive an insurance payout during a year and you do not incur any deductible expenditure in that year of income, there is no assessable recoupment in that income year, under this division.

In the restoration of your property the work will have to be itemised, so that the expenses can be classified into outright deductions, replacement of depreciable assets and any capital works.

Where an expense is deductible in a single income year and the insurance or recoupment has been received in an income year prior to the income year that the deductible expenditure was incurred, subsection 20-35(3) of the ITAA 1997 applies to determine how much of the assessable recoupment is included in your assessable income. When this amount is included in your assessable income the reduced CGT cost base will be increased by this amount, in accordance with subsection 110-45(3) of the ITAA 1997.

Expenses that are incurred in completing repairs that are deductible under section 25-10 of the ITAA 1997 (Taxation Ruling TR 97/23) would trigger the application of the assessable recoupment section and the amount of the insurance payout to the extent of the deductible amounts would become part of your assessable income in the year the expenses were incurred.

Therefore, an insurance payout will be an assessable recoupment when both the insurance payout has been received and deductible expenditure has been incurred. Any excess amount above what is incurred on deductible expenses will not be assessable income to you.

The total of all amounts that subsection 20-35(1) of the ITAA 1997 includes in your assessable income for one or more income years in respect of a loss or outgoing cannot exceed the amount of the loss or outgoing (subsection 20-35(2) of the ITAA 1997).

If a balancing adjustment is required for property (because of the loss or destruction depreciable assets) on which you incurred a loss or outgoing, no part of the termination value of the property is an amount you receive as recoupment of the loss or outgoing, in accordance with subsection 20-25(5) of the ITAA 1997.

If the repair work was carried out by the builder and they are paid by the insurance company, there will be no amount included in your assessable income and there will be no change to the CGT cost base. You are not in the receipt of any payment and have not incurred any expenditure.

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