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Ruling

Subject: Deduction-repairs

Question 1

Are you entitled to a deduction for your share of the costs of the work undertaken to correct deflects identified in your pre-purchased property inspection report?

Answer: No.

Question 2

Are you entitled to a deduction for your share of the costs of the work undertaken to fix the toilet mechanism and broken window panes?

Answer: Yes

Question 3

Are you entitled to a capital works deduction for your share of the costs for the additional work that has been undertaken to the verandah, undamaged tiled areas, the electrical work and the re-sanding, the polishing of the floors and re-glazing of the tiles?

Answer: Yes

Question 4

Are you entitled to your share of a deduction for the decline in value of the replacement of a stove and curtains?

Answer: Yes

Question 5

Are you entitled to a capital works deduction for your share of the costs to replace a vanity unit and laundry tub?

Answer: Yes

Question 6

Are you entitled to a deduction for the removal of a tree?

Answer: No

This ruling applies for the following periods:

Year ended 30 June 2011
Year ended 30 June 2012

The scheme commenced on:

1 July 2010

Relevant facts

You jointly own an investment property.

The property is a brick and stone two storey duplex structure with metal roof and timber flooring.

The property was built a long time ago.

A pre-purchased property inspection report was undertaken the following problems were identified:

· dampness in various areas of the property

· flashing not sealed against a wall

· internal walls had drummy areas as a result of settlement cracking and moisture penetration

· verandah had decay present in the timber edge capping and the decking on the outer edge of the structure and in several support posts

· the stone and brick work had numerous patched cracks and un-patched cracks in several areas of the building and friable (crumbled or reduced to powder) of the mortar patching of the walls

· a portion of the tiled areas of the property appear drummy due to poor adhesion

· the laundry double tub was in poor condition due to significant rust damage around the base of the unit

· the paint internally and externally is reasonable condition and attention is required to deteriorate ceiling in one room which is affected by mould

· bathroom vanity unit is in poor condition

· moisture damage has occurred to the bench tops and kitchen cabinets

· a tree located near the building can cause footing failure and cracking in brickwork due to excessive water extraction from the ground around the building

The property has been made available for rent.

The property was rented until the tenants vacated so work could be carried out to the property.

You believe due to severe wither conditions this caused the mould, paint to peel and damage to kitchen cupboards and plaster this led to bring forward maintenance to item of the property that could have other wised been carried out in future years.

A further inspection of the verandah was undertaken and it revealed extensive damage. It was recommended that replacing the entire front of the verandah to reduce ongoing maintenance and to make the verandah area safe for the tenants.

You received a grant from the local council to facilitate work undertaken to the verandah.

You engaged a number of contractors to undertake the following work:

· to re-tile, sand and varnish the floors

· re-sand and re-glazing the tiled floors as it was cost effective to undertaken this work while the property was vacant and to reduce on ongoing maintenance costs

· replace the verandah posts, top rail of the hand rail and tongue and groove floor boards and repaint, re-nail ceiling boards back into position, repair ceiling joints, repair a corner downpipe, paint the bottom of the post, sills and downpipes

· to undertake work to prevent leaks in stone and brick work

· to undertake work to fix water damage to the property.

· You also had undertaken the following work:

· replace the toilet's flushing mechanism

· replace a number of broken glass window panes

· re-paint a number of rooms of the property

· replace the laundry tub

· electrical repairs as part of the renovation work to the property

· replace all the curtains due to mould and soiling.

The property was rented out after most of the internal work was carried out.

The tenants of the property received a reduction in the rent for the period of time the external work was carried out on the property.

The property returned rental income in a financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 subsection 25-10(3).

Income Tax Assessment Act 1997 section 43-10

Reasons for decision

Section 25-10 of the ITAA 1997 states that expenditure incurred by you for repairs to any premises, or part of premises, plant, machinery, tools or articles held or used by you solely for the purpose of producing assessable income is an allowable deduction. However, a deduction is not allowable if the expenditure is of a capital nature, for example, an improvement.

Taxation Ruling TR 97/23 provides the Tax Office's view on expenditure that is allowable under section 25-10 of the ITAA 1997.

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, or

· 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.

Consequently, what is considered to be a repair for the purposes of section 25-10 is determined by the facts of each case.

The meaning of repairs

The term 'repairs' is not defined in section 25-10 of the ITAA 1997. Therefore, it is necessary to look at its ordinary meaning. Paragraph 13 of Taxation Ruling TR 97/23 states the following: 

The word 'repairs' has its ordinary meaning. It 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.

At paragraph 44, the ruling goes on to state:

 In the case of a 'repair', broadly speaking, the work restores the efficiency of function of the property without changing its character...

Initial repairs

Initial repairs relate to the remedying of defects, damage or deterioration to a property that existed at the time of acquisition and did not arise from the operations of the taxpayer who incurs the repair expenditure (paragraph 4 Taxation Ruling TR 97/23).

Taxation Ruling TR 97/23 at paragraph 59, confirms that expenditure incurred on initial repairs is capital expenditure and is, therefore, not deductible under section
25-10 of the ITAA 1997. This paragraph also states that the cost of effecting initial repairs is still not allowable even if some income has been earned before the repair expenditure is incurred. In other words, the character of initial repairs is not altered because income is derived from the property before the expenses are incurred on the initial repairs.

Furthermore, it is immaterial whether or not you were aware of the need for the repairs at the time of acquisition or if the purchase price reflected the need for repairs (paragraphs 5 and 59-61 of Taxation Ruling TR 97/23; Law Shipping Co Ltd v Commissioners of Inland Revenue (1923) 12 TC 621 and W. Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58; 14 ATD 78; (1965) 9 AITR 710).

Initial repair costs can be dissected or apportioned

An initial repair expense can be dissected or apportioned to allow a deduction under section 25-10 of the ITAA of any part of the expense that remedies deterioration arising from the holding the property for income purposes after it was acquired.

If repair costs are attributable either to damage before property is acquired by a taxpayer or to defects that emerged suddenly and matured by the time of acquisition of the property, no deduction is allowable under section 25-10 in accordance with paragraph 59 of this Ruling. If repair costs are attributable either to damage that occurs during the taxpayer's holding. For example; of the property for income purposes or to defects that emerge suddenly and mature during that time, a deduction is allowable if the other general principles stated in this TR 97/23 are satisfied.

For further information on the methods of apportionment refer to paragraph 65 of TR 97/23 which is available of the Australian Taxation Office website at www.ato.gov.au

Replacement of a subsidiary part or an entirety.

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

(a) the property is separately identifiable as a principal item of capital equipment; or

(b) 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; or

(c) the thing or structure is a separate and distinct item of plant in itself from the thing or structure which it serves; or

(d) the thing or structure is a 'unit of property' as that expression is used in the depreciation deduction provisions of the income tax law (paragraph 38 of TR 97/23).

Property is more likely to be a subsidiary part rather than an entirety if:

(a) it is an integral part of some larger item of plant; or

(b) the property is physically, commercially and functionally an inseparable part of something else (paragraph 39 of TR 97/23).

Improvement v repair

This distinction is discussed at paragraphs 44 to 54 and 120 to 124 of TR 97/23. In regards to repairs versus improvements and the use of different material, the Commissioner accepts that the use of a different material does not necessarily prevent the work from being a repair, provided the work merely restores a previous function to the property or restores the efficiency of the previous function. Whether the use of a more modern material to replace the original material qualifies as a repair is a question determined on the facts of each case. It is restoration of a thing's efficiency of function (without changing its character) rather than exact repetition of form or material that is significant.

The principles outlined in paragraphs 44 to 46 were established in W Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58; (1965) 14 ATD 78 and Federal Commissioner of Taxation v. Western Suburbs Cinemas Ltd (1952) 86 CLR 102.

Substantial improvements, additions, alterations and modernisations are not repairs. Some of the factors pointing to an improvement rather than a repair are whether: the modification work has effected an improvement to the asset; there is greater efficiency of function of the property; there is an increase in the value of the asset; and the expenditure reduces the likelihood of future repairs.

Decline in value.

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.

Capital works

Under Division 43 of the ITAA 1997 a taxpayer can claim a deduction for capital expenditure incurred in constructing capital works, including buildings and structural improvements. Under section 43-10 of the ITAA 1997, a taxpayer can claim a deduction for capital expenditure incurred in constructing capital works, including buildings and structural improvements. The deduction is either 2.5% of the construction expenditure, depending on when construction started and how the capital works are used.

In the case of residential rental properties, a taxpayer can deduct certain kinds of construction expenditure and the deduction is generally spread over a period 40 years. In cases where building or structural improvements started after 15 September 1987, a deduction can be claimed an annual rate of 2.5 % of the construction expenditure for a period of 40 years.

A deduction is only available for the number of days that a property is rented, or available for rent, in any income year from the date that the works are completed.

Application of the above to your situation 

In your case, a review of the pre-purchased property inspection report indicates that the property had suffered from a number of defects that were in need of repairs.

Internal Walls

The work undertaken to fix the drummy areas of the internal walls and the mould in one of the rooms is an initial repair and is capital in nature as none of this work arose in the course of you renting out the property. This would include expenses such as materials used fix the drummy area, any re-plastering and re-painting of property. It is considered the unfavourable weather conditioned merely accentuated the defects which were identified in the pre-purchase inspection report. Therefore a deduction under section 25-10 of the ITTA 1997 is not available.

Stone and Brick work

It was noted in the per-purchase inspection report that the property had suffered from moisture penetration due to the unsealed solid wall construction, damage or loose damp course, cracking and drummy mortar, and the effects of settlement cracking and moisture penetration in some of the masonry, stone and brick work walls. Where work has been undertaken to correct these problems, this work is considered an initial repair as none of this work arose in the course of you renting out the property and is capital in nature and not deductible under section 25-10 of the ITAA 1997. It is also considered the unfavourable weather conditioned merely accentuated the defects which were identified in the pre-purchase inspection report.

Verandah

Similarly where work has been undertaken to repair the existing damage as noted in the per-purchase inspection report this also is consider an initial repair as none of this work arose in the course of you renting out the property. Further, where additional work has been undertaken to the verandah area this is considered not to be a repair as there is no evidence to indicate that this work has been undertaken to remedy deflects that arose during the time the property was income producing and a deduction is not available under section 25-10 of the ITAA 1997.

The cost of this additional work is considered an improvement as it has extended the property's income-producing ability and arguably has increased in the value of the property. This expenditure is capital nature and deductible under Division 43 of the ITAA 1997.

Electrical work

You have undertaken renovation to various areas of the property. You advised that as a result of this work, further work was required to the electrical system in the property. You have not identified what electric work was undertaken. Where the electrical work has been undertaken in conjunction with work to refurbish the property, this work is also considered capital in nature and not a repair as none of this work arose in the course of your renting out the property.

Tiling

You have undertaken work to correct poor adhesion of the tiled area of the property, as this defect was noted in the per-purchase inspection report. Any work undertaken to rectify this problem is considered an initial repair and is capital in nature. Where work to replace the undamaged tiled areas has been undertaken as part of rectifying the poor adhesion of tiled areas, this work is also considered capital in nature and not a repair as none of this work arose in the course of you renting out the property. The cost of replacing the undamaged tiled areas is considered an improvement as it has extended the property's income-producing ability and arguably has increase in the value of the property. As this expenditure is capital nature and deduction is available under Division 43 of the ITAA 1997.

Re-sanding, the polishing of the floors and re-glazing of the tiles

The re-sanding and polishing of the floors was undertaken as a result of the renovation to the property, we consider this work to be an improvement to the property. The re-sanding, the polishing of the floors and re-glazing of the tiles performed on the property as part of the renovation has resulted in an increase in the value of the property and also extended the property's income-producing ability.

The total material and labour costs associated with re-sanding and polishing of the floors and re-glazing of the tiles are considered to be capital in nature and deduction is available under Division 43 of the ITAA 1997.

The toilet and window pane

A review of the property's per-purchase inspection report indicates that none to these problems were identified. As there is no evidence to indicate that this work is part of the defects indentified in the report we considered these problems arose during the time the time the property was income producing. A deduction is available under section 25-10 of the ITAA 1997 for this work.

Laundry tubs and vanity unit

It was noted in the per-purchase inspection report that the vanity unit and laundry tubs were in poor condition due to water damage and rusting. The replacement of these items is considered is capital in nature. As the expenditure is capital in nature it is not deductible under section 25-10 of the ITAA 1997.

Replacement of the curtains and stove

As these items are considered assets for depreciation purposes, you are entitled to a deduction under Division 40 of the ITAA 1997 as the property was used for income producing purposes during the financial year.

Tree removal

It is also noted in the per-purchase inspection report that the trees were identified as a problem as they may causes damage to the footing and brickwork. The removal of tree is not considered to be a repair as there is no replacement or correction of defects in or damage to the trees. The tree was removed was to eliminate any potential risk and is no longer in existence. Therefore, the costs associated with the removal of the tree is considered to be capital in nature and are not deductible under sections 8-1 or 25-10 of the ITAA 1997. Similarly you are not entitled to a deduction for the cost of removing the trees under the capital work provisions as the cost is not considered to be building or structural improvements.

Note: As the cost of removing the trees is capital in nature, it may form part of the cost base of the rental property for capital gains tax (CGT) purposes on the disposal of the property.

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