Edited version of private advice

Authorisation Number: 1051805238867

Date of advice: 24 March 2021

Ruling

Subject: Rental property repairs

Question 1

Is the cost of restumping the Property deductible as a repair as per section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

No

Question 2

Is the cost of restumping the Property classified as capital works as per Division 43 of the ITAA 1997?

Answer 2

No

Question 3

Is the cost of restumping the Property to be added to the cost base as an initial repair in accordance with section 110-25 of the ITAA 1997?

Answer 3

Yes

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You purchased the Property on XX/XX/XXXX.

As part of the purchase process you commissioned an independent building inspection.

The building inspection was undertaken during the purchase process, and a Report was provided. The Report notes the below average condition of the Property, the high incidence of major and minor defects, information on the building age, information in relation to timber floors, footings and subfloor and recommendations to obtain local council inspection reports and engage licensed builders to undertake further evaluations.

A local council building report was not provided.

The Property was used for income producing activities from XX/XX/XXXX until XX/XX/XXXX.

The tenant vacated and the rental bond was refunded to the tenant on XX/XX/XXXX.

You provided screenshots of X text messages indicating you were notified of an issue with the footings on XX/XX/XXXX when you were in the process of organising new tenants.

You provided a copy of an email from Person A from Company A dated XX/XX/XXXX. The email confirms an inspection was carried out and outlines the deterioration to the beams, stumps and footings.

You provided a copy of a contract (Contract) from Person B (Contractor) to lift the Property and re stump. The contract was signed on XX/XX/XXXX You and the Contractor. Contract price $XX,XXXX.

You provided Tax Invoices from the Contractor relating to the Contract.

You provided before and after photos of the work undertaken on the stumps as per the Contract.

You did not receive a copy of the financial institutions property valuation report undertaken at the time of purchase.

No formal rental inspection report was undertaken prior to commencement of the Contract.

The expenses were not covered by any insurance or other monetary recovery.

The Property remains untenanted. However, you stated your intention is to once again rent the property out.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 section 110-25

Reasons for decision

Section 25-10 of the Income Tax Assessment Act 1997 (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 following are examples of expenses which are capital or of a capital nature:

•                     replacement of an entire structure or unit of property (such as a complete fence or building, a stove, kitchen cupboards or refrigerator)

•                     improvements, renovations, extensions and alterations, and

•                     initial repairs, for example, in remedying defects, damage or deterioration that existed at the date you acquired the property

Taxation Ruling TR 97/23 Income tax: deductions for repairsexplains the principles and the circumstances in which expenditure incurred for repairs is an allowable deduction.

The term 'repair' means the remedying or making good of defects in, damage to, or deterioration of, property to be repaired and contemplates the continued existence of the property. Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing its character and may include restoration to its former appearance, form, state or condition. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated.

Repair costs are deductible where they are incurred during the period the property is held for income producing purposes and are attributable either to damage that occurs during your income producing use of the property or to defects that emerge suddenly during that time.

Expenditure for repairs to property is capital expenditure if the expenditure, rather than being for work done to restore the property by renewal or replacement of subsidiary parts of a whole, is for work that is a renewal in the sense of a reconstruction of the entirety.

Entirety

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

The term 'entirety' is used by the courts in repair cases to refer to something 'separately identifiable as a principal item of capital equipment' (Lindsay v FC of T (1960) 106 CLR 377 at 385; (1960) 12 ATD 197 at 201 (the Lindsay case)).

In the Lindsay case, the taxpayer company was a slip proprietor and ship repairer. It claimed a deduction for the cost of reconstructing one of two slipways. In finding that the work was not repairs, Kitto J rejected the taxpayer's submission that either the whole slip (comprising the slipway, hauling machines, cradles and winches by which vessels were manoeuvred on to it) or the whole of the business premises containing the slipway should be regarded as the relevant entirety. His Honour decided that the slipway was an entirety by itself and not a subsidiary part of a larger whole.

In the case of WG Thomas & Co Pty Ltd v FC of T (1965) 115 CLR 58; (1965) 14 ATD 78, which involved a claim for general repairs to a building, it was said that the question was not whether the roof or floor or some other part of the building, looked at in isolation, was repaired as distinct from wholly reconstructed, but whether what was done to the floor or the roof was a repair to the building.

Relevantly, paragraph 40 of TR 97/23 describes a building as the entirety, and something that is part of the building, such as a roof or wall is considered to be a subsidiary part rather than the entirety.

Property is more likely to be an entirety, as distinct from a subsidiary part, if:

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

•                     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

•                     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 or structure is a 'unit of property' as that expression is used in the depreciation deduction provisions of the income tax law.

Initial repair

Paragraph 59 of TR 97/23 states that expenditure incurred on an initial repair after a rental property is acquired, where the expenses are incurred in remedying defects, damage or deterioration in existence at the date of acquisition, is capital expenditure and is not, therefore, deductible under section 25-10 of the ITAA 1997.

The cost of effecting an initial repair is still not deductible even if some income happens to be earned after acquisition but before the repair expenditure is incurred.

Paragraphs 60 of TR 97/23 state that the main consideration in relation to initial repairs is the appearance, form, state and condition of the property and its functional efficiency when it is acquired. Expenditure that remedies some defect or damage to, or deterioration of, property is capital expenditure if the defect, damage or deterioration:

(a) existed at the time of acquisition of the property; and

(b) did not arise from the operations of the person who incurs the expenditure.

It is not considered material whether you were aware of the condition or the need for repair of the property at the time of purchase. Expenditure on initial repairs lacks a connection to the income producing activities of the property and is considered an additional cost of acquiring the property or an improvement in the quality of the property you acquired. Initial repair expenditure relates to the establishment of the profit - yielding structure. It is capital expenditure and is not deductible under section 25-10 of the ITAA 1997.

Capital works

In some situations, depending on what the expenditure was for, initial repair expenses may be classified as capital works. Capital works is used to describe certain kinds of construction expenditure on buildings, structural improvements, extensions and alterations.

Division 43 of the ITAA 1997 provides a deduction for capital works. Under Division 43 of the ITAA 1997, a deduction for capital works is dependent, among other things, on whether there is 'construction expenditure' for the capital works, which is defined in subsection 43-70(1) of the ITAA 1997 as 'capital expenditure incurred in respect of the construction of capital works'.

Taxation Ruling TR 97/25 Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements addresses a number of matters that are relevant in determining entitlement to, and the amount of, a deduction under Division 43 of the ITAA 1997 in respect of expenditure on the construction of assessable income producing buildings and other capital works. It also identifies certain expenses that are included in construction expenditure.

Paragraph 7 of TR 97/25 outlines the three categories of capital works in respect of section 43-20 of the ITAA 1997 as:

•                     Buildings or extensions, alterations or improvements to buildings

•                     Structural improvements or extensions, alterations or improvements to structural improvements; and

•                     Environment protection earthworks

The Rental properties 2020 guide provides on page 28 the following examples of construction expenditure:

•                     a building or an extension, for example, adding a room, garage, patio or pergola

•                     alterations, such as removing or adding an internal wall, or

•                     structural improvements to the property, for example, adding a gazebo, carport, sealed driveway, retaining wall or fence.

If the conditions are satisfied, capital works deductions may be claimed. In the case of residential rental properties, the deductions would generally be spread over a period of 25 or 40 years.

Cost base

The cost base of a capital gains tax (CGT) asset is generally the cost of the asset when you bought it. However, it also includes certain other costs associated with acquiring, holding and disposing of the asset.

Section 110-25 of ITAA 1997 states that a CGT asset's cost base consists of five elements. You need to add together all these elements to work out your cost base for each CGT asset.

Taxation Determination TD 98/19 Income tax: capital gains: may initial repair expenditure incurred after the acquisition of a CGT asset be included in the relevant cost base of the asset? outlines that initial repair expenditure incurred after the acquisition of a CGT asset is included in the fourth element of the cost base and reduced cost base of the asset. The fourth element relates to capital expenditure incurred to preserve the value of your asset as per section 110-25(5) of the ITAA. The expenses will be taken into account when calculating the capital gain or loss on a CGT asset when it is disposed of in the future.

Application to your circumstances

According to the Report the building was at least XX to XX years old prior to You purchasing the Property.

You say that soon after settlement the rust on the stumps was removed, the deteriorated areas were treated and repainted. However, there is no evidence that this occurred. The inspection carried out by Company A approximately X years after settlement indicates several stumps were showing signs of rust at ground penetration level and some stumps had rust holes through their entire wall thickness.

The Report notes the below average condition of the Property which provides an indication that the defects and deterioration to the stumps were already in existence at the date of acquisition. The reference to the poor workmanship of the builders in the text message also lends support to this view.

There was no evidence provided showing the issues with the stumps which resulted in the repairs occurred since You purchased the rental Property. We accept you only became aware of the extent of the defects after the tenant left in XXXX. However, it is irrelevant whether you were aware of the issue at the time of purchase.

Thus, the Commissioner considers the defects and damage to the stumps were present at the time the Property was acquired in accordance with TR 97/23. Therefore, these repairs would constitute an initial repair and You are not entitled to claim deductions under section 25-10 of the ITAA 1997 as initial repairs are capital expenditure or capital in nature.

Consideration was given to whether a capital works deduction contained in Division 43 of the ITAA 1997 may be allowable for any construction expenditure that is not excluded under subsection 43-70(2) of the ITAA 1997.

The house needed to be lifted, the old stumps were extracted and removed, and new stumps installed. The restumping constitutes a repair, not an improvement. The restumping undertaken replaced those already there to restore the original efficiency of function of the foundations to support the house. The work to the stumps did not change the nature and character of the house. The house was returned to the original height above ground level and the house was not upgraded in any other way than stated in the Contract. It is considered the stumps are only part of the house and does not constitute an entirety. The house itself is the entirety.

Based on the information provided and applying the relevant legislation and principles to the facts of your situation, it has been determined that the initial repair expenses are not construction expenditure and not deductible under Division 43 of ITAA 1997.

As the expenses are not deductible immediately or over several years, they may be included in the cost base of the Property. These expenses can be included in the fourth element being a capital cost to preserve the value of your asset as per section 110-25(5) of the ITAA. It will be taken into account when calculating the capital gain or loss on the property when you dispose of it in the future.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).