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Ruling

Subject: Rental deductions

Question 1

Are you entitled to an outright deduction for the replacement of the floor coverings and the kitchen cupboards?

Answer

No.

Question 2

Are you entitled to claim a decline in value deduction for the replacement floor coverings?

Answer

Yes.

Question 3

Are you entitled to a capital works deduction for the replacement kitchen cupboards?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You own a rental property that suffered flood damage.

You replaced the carpet in the property and work was done to the kitchen.

The kitchen cupboards had to be replaced, but you were able to reuse the bench tops as these were not damaged by the flood.

Overall the kitchen was restored to its original pre-flood condition.

You did not receive any insurance proceeds for the damage.

The carpet that was replaced did not have an adjustable value (written down value) for depreciation purposes.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 25-10.

Income Tax Assessment Act 1997 Section 40-10.

Income Tax Assessment Act 1997 Subsection 40-45(2).

Income Tax Assessment Act 1997 Section 43-10.

Income Tax Assessment Act 1997 Section 43-25.

Reasons for decision

Summary

You are not entitled to an outright deduction for the work completed on your rental property as the expenditure is capital in nature.

Some of the capital expenditure is in relation to a new depreciating asset for which you can claim a decline in value deduction. Carpet is a depreciating asset for which you can claim a deduction for the decline in value.

The replacement of the kitchen cupboards is considered capital expenditure and qualifies for the 2.5% capital works deduction.

Detailed reasoning

The general deduction provision is section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) which allows a deduction for expenditure incurred in gaining or producing assessable income except where it is of a capital nature, private or domestic nature or relates to the earning of exempt income.

A deduction for expenditure incurred for repairs to property used to produce assessable income is specifically allowed under section 25-10 of the ITAA 1997. However, as with section 8-1 of the ITAA 1997, the expenses must not be capital in nature.

The renewal, replacement, or reconstruction of, the whole or substantially the whole of a thing or structure (entirety) is likely to be considered a capital expense rather than a deductible repair.

Determining what is an entirety is a question of fact in each case. According to Taxation Ruling TR 97/23, property is more likely to be an entirety if:

· The property is separately identifiable as a principal item of capital equipment.

· The thing or structure is an integral part, but only a part, of entire premises and is capable of providing a useful function without regard to any other part of the premises.

· The thing or structure is a separate and distinct item of plant in itself from the thing or structure which it serves, or

· The thing is a unit of property as that expression is used in the depreciation deduction provisions of the income tax law.

Where expenditure in relation to a rental property is capital in nature and therefore not allowable as an outright deduction under sections 8-1 or 25-10 of the ITAA 1997, a deduction spread over time may be available. This may be a capital works deduction under Division 43 of the ITAA 1997 or a decline in value (depreciation) deduction under Division 40 of the ITAA 1997.

A capital works deduction is generally claimed at a rate of 2.5% over 40 years and is for construction expenditure in relation to a building.

Expenditure on plant is specifically excluded from the capital works deduction.

A decline in value deduction is claimed over the effective life of a depreciating asset (including plant) used for income producing purposes. This deduction cannot be claimed where a capital works deduction for the item is allowable (subsection 40-45(2) of the ITAA 1997).

The issue of whether an item is plant is significant as it is relevant in determining whether a capital works deduction or a decline in value deduction is available. A residential rental property is almost always the setting of the landlord's rental income earning activities and not within the ordinary meaning of plant. Similarly an item that forms part of those premises is part of that setting and not within the ordinary meaning of plant.

It is a question of fact and degree as to whether an item forms part of the premises. The following are relevant matters to consider when determining that question:

· whether the item appears visually to retain a separate identity;

· the degree of permanence with which it has been attached;

· the incompleteness of the structure without it; and

· the extent to which it was intended to be permanent or whether it was likely to be replaced within a relatively short period.

Depreciating assets

Section 40-25 of the ITAA 1997 states that you can deduct an amount for the decline in value of a depreciating asset you hold to the extent that you use it for a taxable purpose. The term 'depreciating asset' is defined in subsection 40-30(1) of the ITAA 1997 as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

However, subsection 40-45(2) of the ITAA 1997 provides that Division 40 of the ITAA 1997 does not apply to capital works to the extent that an amount is or could have been deductible under Division 43 of the ITAA 1997.

Subsection 40-80(2) of the ITAA 1997 provides that the decline in value of a depreciating asset will be the cost of the asset if the cost of the asset does not exceed $300 and the asset is used predominately for the production of assessable income.

Expenses incurred to replace carpets are capital in nature and not deductible as a repair under section 25-10 of the ITAA 1997. However, these items are depreciating assets as they have a limited effective life and can reasonably be expected to decline in value over the time they are used in the rental property.

In your case, you have purchased and installed new carpet for your rental property that was damaged due to the floods. As the carpet is a depreciating asset within the meaning of subsection 40-30(1) of the ITAA 1997 and used for a taxable purpose as defined in section 40-25 of the ITAA 1997, you are entitled to claim a deduction for the decline in value of the asset under Division 40 of the ITAA 1997.

To work out the amount of deduction allowable for the decline in value of the carpet for each relevant year of income, you can:

· work out a deduction for the decline in value of a depreciating asset using either the diminishing value method or the prime cost method,

· make your own estimate of the asset's effect life, or

· use the effective life determined by the Commissioner.

Capital works deduction

Broadly speaking, section 43-10 of the ITAA 1997 provides a deduction for capital expenditure on capital works used to produce assessable income. Capital works include a building or an extension, alteration or improvement to a building and includes the kitchen cupboards.

The kitchen cupboards are separately identifiable items with their own function. As a consequence, they are an entirety in themselves and their replacement is a renewal of the entirety. The expenditure is capital in nature (Lindsay v. Federal Commissioner of Taxation (1961) 106 CLR 377; [1961] HCA 93).

The cupboards are fixtures and, therefore, a part of the building because they satisfy the 'degree of annexation' and the 'object of annexation' tests that are generally applied to determine whether there is a fixture at common law. The cupboards are not in place simply by their own weight but are screwed to the walls of the building and they are fixed with the intention that they shall remain there indefinitely.

The deduction under section 43-10 of the ITAA 1997 is based on the amount of construction expenditure. This is defined in subsection 43-70(1) of the ITAA 1997 as capital expenditure incurred in respect of the construction of the capital works. Paragraph 43-70(2)(e) of the ITAA 1997 excludes expenditure on plant from construction expenditure.

The role and function of the cupboards in relation to the income producing activities do not go beyond being part of the setting of an income producing operation when they are installed in a residential rental property. As a result, they are not plant.

The expenditure on the kitchen cupboards is construction expenditure for which a deduction is available under section 43-10 of the ITAA 1997. A deduction for the expenditure is not available under Division 40 of the ITAA 1997 because a deduction is available under Division 43 of the ITAA 1997 (see subsection 40-45(2) of the ITAA 1997).

You are therefore entitled to a deduction for capital works under section 43-10 of the ITAA 1997 for the replacement of the kitchen cupboards.

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