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Ruling

Subject: rental deductions

Question 1

Are you entitled to a deduction for repairs for the costs incurred in relation to underpinning your rental property?

Answer

No

Question 2

Are you entitled to a deduction for capital works for the costs incurred in relation to underpinning your rental property?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts and circumstances

You purchased a property in the 2007-08 income year.

The property was continuously rented from the date of acquisition to the 2009-10 income year.

In 2010 cracks began to appear in the plaster and brickwork in several areas of the building.

In 2010 you sought an expert report to detail the damage and the necessary work required to repair the damage.

The report includes the following information:

· The entire house founds on a concrete raft slab.

· The inspection was required to determine the causes of the cracking to the full masonry walls and possible recommendations for repair.

Identified damage included:

· Extensive cracking at the external and internal ground floor walls.

· The damage is confined to the entire South East side of the dwelling and is most extreme at the kitchen walls.

· Gaps opening up between windows and exterior masonry walls

· The front concrete porch has moved and subsided away from the side of the house approximately 40 to 50mm.

· Gaps opening between discontinuities between the front driveway and footpaths.

Identified possible causes:

· The footings and slab beams are inadequate and the damage worsened by the lack of vertical articulation of the masonry walls.

· The footings and slab beams are founded in fill material and have under gone excessive settlements and the damage worsened by the lack of vertical articulation of the masonry walls.

· The footings and slab beams have been affected by adverse moisture conditions due to the presence of adjacent tree roots and highly reactive soils, the damage worsened by the lack of vertical articulation of the masonry walls.

· A leak in a water pipe weakening the soil structure, which could explain the sudden failures.

· Combinations of the above possible causes.

Recommendations included:

· Internal masonry walls to be propped and made safe at the kitchen and living room areas by a licensed and registered builder as soon as possible. The props are not to be removed until all repair works have been carried out.

· A soil investigation and report by a geotechnical engineer is required to determine the soil type, existing footing sizes and adequacy, bearing capacity of the soil and the cause of the damage related to footing movements. The report should include recommendations of the type and extent of repair works to footings and slab beams and masonry walls to minimise or stop the damage occurring.

You received further verbal advice from engineers who recommended that underpinning take place to the concrete slab to return the slab to its original position.

The underpinning work took place in the 2010-11 income year.

The plans provided show that underpinning took place to the entire perimeter of the house.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1,

Income Tax Assessment Act 1997 Section 25-10,

Income Tax Assessment Act 1997 Division 43,

Income Tax Assessment Act 1997 Section 43-10 and

Income Tax Assessment Act 1997 Section 43-20.

Reasons for decision

Summary

The underpinning of the house is considered to be an improvement and is capital in nature. Therefore, you are not entitled to a deduction under section 25-10 or 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). However, you are entitled to a deduction for capital works under section 43-10 of the ITAA 1997, to be spread over 40 years.

Detailed reasoning

Section 8-1 of the 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.

Section 25-10 of the ITAA 1997 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.

The word 'repair' is not defined within the taxation legislation. Taxation Ruling TR 97/23 states that the word 'repair' ordinarily means the remedying or making good of defects in, damage to, or deterioration of, property to be repaired (being defects, damage or deterioration in a mechanical and physical sense) and contemplates the continued existence of the property.

In W Thomas & Co v. Federal Commissioner of Taxation (1965) 115 CLR 58; (1965) 14 ATD 78; (1965) 9 AITR 710, it was held that a 'repair' involves a restoration of a thing to a condition it formerly had without changing its character. It is the restoration of efficiency in function rather than the exact repetition of form or material that is significant.

Taxation Ruling TR 97/23 indicates that expenditure for repairs to property is of a capital nature where:

· the extent of the work carried out represents a renewal or reconstruction of the entirety

· the works result in a greater efficiency of function in the property, therefore representing an 'improvement' rather than 'repair', or

· the work is an initial repair.

This issue of whether underpinning foundations is repairs or capital works was considered in AAT Case V2 88 ATC 107. In that case a block of flats was built on improperly compacted landfill and the foundations in one corner of the property were found to be barely adequate. The flats were purchased by the taxpayer in 1980 and a condition of the sale was that the foundations be improved. The improvements were made. However, further subsidence occurred and in 1985 the taxpayer was required to make extensive repairs to the foundations. The repairs involved removing the previous foundation and replacing it with three columns on a solid wall foundation. To provide further support a wall of masonry blocks reinforced with steel and concrete was constructed between the columns.

In that case Senior Member Mr Beddoe considered that the question at issue was whether the repair to the foundation had altered the character of the building. In considering that question Senior Member Mr Beddoe quoted, with approval, ACT Construction Ltd v Customs & Excise Commissioners [1979] 2 All ER 691 (ACT Construction case). In the ACT Construction case certain houses had suffered subsidence due to shallow foundations. The foundations had complied with the building codes at the time the houses were built but did not comply with the more modern codes. In rectifying the problem it was necessary to underpin the existing foundations. Drake J stated: (at p 696)

-... on the basis that all of these houses had defective foundations, too shallow to comply with modern building regulations and which had already resulted in subsistence, I had no hesitation in taking the view that the character and nature of these premises were altered by the work done, and that the work cannot be termed repair or maintenance...-

Senior Member Mr Beddoe agreed with the above, but ruled that the work carried out in AAT Case V2 was not of a capital nature. In his reasons he stated (at p 112):

-If the applicant had found it necessary to have all of the foundations replaced or upgraded as in ACT Construction I would be of the view that the work had changed the character and nature of the building. However that was not the case and it was only necessary to repair the north-west corner and that became necessary because of outside influences (the unusually dry season and the mango trees) rather than an inherent defect in the structure. There was no change in the character and nature of the building.-

You contend that the work was carried out to restore the property to its former efficiency in function and would therefore not be considered an improvement to the property. However, the rectification works undertaken require the perimeter whole of the concrete slab to be underpinned. The expert report that you provided detailed that the current damage was confined to the south east side of the house. The extent of these works is therefore considered to be a capital improvement.

The costs you incur are capital in nature and are not a repair. Therefore, you are not entitled to claim a deduction for the expenditure incurred under section 8-1 or section 25-10 of the ITAA 1997.

Capital Works

A deduction is available, under Division 43 of the ITAA 1997, for construction expenditure for capital works. Construction expenditure is defined in subsection 43-70(1) of the ITAA 1997 as 'capital expenditure incurred in respect of the construction of capital works'.

Section 43-20 of the 1997 Act recognises three categories of capital works:

· buildings or extensions, alterations or improvements to buildings;

· structural improvements or extensions, alterations or improvements to structural improvements; and

· environment protection earthworks.

Taxation Ruling TR 97/25 discusses the deductibility of capital expenditure on construction of income producing capital works, including buildings and structural improvements.

We consider that construction expenditure includes:

· preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits;

· cost of structural features that are an integral part of the income producing buildings or income producing structural improvements, such as atriums and lift wells; and

· some portion of indirect costs.

In the case of residential rental properties, the deduction is generally spread over a period of 25 or 40 years. The deduction is limited to 100% of the construction expenditure. No deduction is allowable until the construction is completed.

Deductions may only be claimed for the period during the year a property is rented or available for rent.

The amount of the claimable deduction depends on when the construction started, the type of construction and the purpose for which the completed capital works are used. For construction started after 15 September 1987 the amount of claimable deduction is 2.5% of the construction expenditure per year over a period of 40 years.

The expenses you incurred to underpin the concrete slab of your rental property are considered to be capital works expenditure. Therefore, you are entitled to a deduction for capital works in accordance with Division 43 of the ITAA 1997.

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