Edited version of private advice

Authorisation Number: 1051814931535

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Date of advice: 10 March 2021

Ruling

Subject: Rental - deductions - repair v improvement

Question 1

Are you entitled to an immediate deduction for the expenses incurred rectifying the damage to the bathroom, replacing the air conditioner or the septic tank?

Answer

Yes.

Question 2

Are you entitled to claim a capital works deduction for expenses incurred in relation to the bathroom?

Answer

No.

Question 3

Are you entitled to an immediate deduction for the expenses incurred rectifying the damage to the jetty?

Answer

Yes.

Question 4

Are you entitled to a decline in value deduction for the expenses incurred replacing the air conditioner?

Answer

Yes.

Question 5

Are you entitled to claim a capital works deduction for expenses incurred in replacing the septic tank?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You own a rental property.

You did not get a building report or pest inspection report when you purchased the property.

After settlement of the property a pest inspection was carried out, which is when the white ants were then found and subsequently treated. You now get bi-annually pest inspections and there have since been no white ants found.

Bathroom repairs were necessary because of a collapsed floor due to extensive termite damage.

It is suspected that more than one person was in the bathroom at a time and under the increased load the floor was damaged and was on the verge of total collapse.

You were invoiced for the bathroom repairs. The repairs included some wall tiles, structural beams, a new concrete sheet floor, a toilet, a shower floor, joinery and associated plumbing which were all damaged when the floor dropped.

You were invoiced repair the jetty at the property. A renter left their boat tied to the jetty during bad weather which resulted in some of the posts of the jetty needing to be replaced to mitigate any risk to anyone else who rented the property.

You were invoiced for the replacement of a damaged air conditioner.

Urgent repairs are also required to the property's septic tank which has been damaged by tree roots. You have received a quote to replace the septic tank. You have been advised that the tree root problem will continue, and further repairs will need to be carried out if the septic tank is just repaired.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 25-10

Income Tax Assessment Act 1997 Section 40-25

Income Tax Assessment Act 1997 Division 43

Reasons for decision

Deductions for repairs

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to the property used for income producing purposes.

However, expenses which are capital, or of a capital nature are not deductible as repairs or maintenance. 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 repairs explains the circumstances in which deductions for repairs are allowable under section 25-10 of the ITAA 1997.

TR 97/23 states that in its context in section 25-10 of the ITAA 1997, 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 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.

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 High Court considered whether the replacement of a slipway was a repair or replacement of an entirety. The court held that the slipway was the relevant entirety on the ground and that it was not a subsidiary part of anything else but was separately identifiable as a principal item of capital expenditure.

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.

Paragraph 60 of TR 97/23 states 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.

An initial repair expense is not the type of repair expenditure ordinarily incurred as a working or operating expense in producing assessable income or in carrying on a business. This is because it lacks a connection with the conduct or operations of the taxpayer that produce the taxpayer's assessable income. It is essentially an additional cost of acquiring the property or an improvement in the quality of the property 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.

Decline in value (Capital Allowances)

Section 40-25 of the ITAA 1997 allows a deduction for the decline in value of a depreciating asset that you hold. A depreciating asset is an asset that can reasonably be expected to decline in value over time it is used (section 40-30 of ITAA 1997)

Depreciating assets are those items that can be described as plant, which do not form part of the premises. These items are usually: separately identifiable; not likely to be permanent and expected to be replaced within a relatively short period and not part of the structure. Examples of assets that deductions for decline in value can be applied to include: timber flooring, carpets, curtains, appliances like a washing machine or fridge and furniture

Capital works

Division 43 of the ITAA 1997 provides a deduction for capital works. Capital works includes buildings and structural improvements, and also extensions, alterations or improvements to buildings and structural improvements where a residential property is used for income producing purposes.

Application to your situation

Bathroom

In your situation, you acquired the property and after settlement you had a pest inspection undertaken. The pest inspection discovered white ants which were subsequently treated. No white ants have been found since the treatment. The bathroom repair was necessary due to a collapsed floor from extensive termite damage. Consequently, the need for repairs arose from damage that existed when the property was purchased. Therefore, the work undertaken was an initial repair and you cannot claim an immediate deduction under section 25-10 of the ITAA 1997 for the cost of the works to the bathroom.

Alternatively, even if the bathroom was not deemed to be an initial repair, a bathroom is a separately identifiable capital item with its own function. As a consequence, it is an entirety in itself and its replacement is a renewal of the entirety. The expenditure is capital in nature and not a deductible repair.

Although an immediate deduction is not available for the full cost of the work to the bathroom, a capital works deduction is allowed at the rate of 2.5% each income year while the property is used for income producing purposes.

Jetty

In your case, you repaired the jetty following damage caused during a guest's stay. The jetty has been restored to its original condition, function and appearance. The work is not regarded as an improvement. Also, the work does not constitute the replacement of an entirety as it was only parts of the jetty that were replaced. It is also not an initial repair as the damage occurred since you acquired the property. Therefore, the associated expenses to repair the jetty are deductible repairs under section 25-10 of the ITAA 1997.

Air conditioner

You replaced a faulty air conditioner. An air conditioner is a depreciating asset as it has a limited effective life and can reasonably be expected to decline in value over the time it is used. As you use this depreciating asset in your rental property you are entitled to claim a deduction for its decline in value under section 40-25 of the ITAA 1997. Please note as the air-conditioner is a capital item an immediate repairs deduction is not allowed under section 25-10 of the ITAA 1997.

Septic tank

Your septic tank has been damaged by tree roots and you have obtained a quote to replace it. The replacement of the septic system is not a repair of an existing part or function of the original system, rather it replaces the entirety.

Therefore, the purchase and installation of a new septic system is not a repair but is capital expenditure and as such, a deduction is not allowable under section 25-10 of the ITAA 1997. A capital works deduction is allowed at the rate of 2.5% each income year while the property is used for income producing purposes.

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