Edited version of private advice

Authorisation Number: 1052095567636

Date of advice: 29 March 2023

Ruling

Subject: Rental deductions - repairs

Question 1

Are the expenses totalling $XX,XXX incurred on the inclinator for the rental property deductible as repairs?

Answer

No.

Question 2

Are the entire expenses totalling $XX,XXX incurred on landscaping for the rental property deductible as repairs?

Answer

No.

This private ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The taxpayers purchased a residential property for $X.XXX.XXX.XX. Settlement occurred on XX/XX/20XX.

The property was purchased for the purpose of leasing the property on a short-term rental basis. The property is rented through the digital platforms.

The property was first made available for rent shortly after settlement. The rental income and expenses were recorded in the taxpayer's income tax returns in the income year of purchase.

The property was available for rent for the following income year except for the Christmas period.

The taxpayers manage the short-term rental listings with the digital platforms, bookings, cleaning and maintenance. The arrangement is commercial and there is no relationship with the tenants. The property is rented at market rates based on comparable rent on the digital platforms.

The property is a house located on a hill. An inclinator is required to access the property up the steep slope.

Before the purchase of the property, the taxpayers obtained documents from the vendor regarding previous maintenance and retrofit works completed on the inclinator. The work was performed in the income year of purchase.

The inclinator ceased working from the time the taxpayers purchased the property. The taxpayers sought advice to complete work on the inclinator. However, the stoppages continued.

A new company was engaged who advised some of the problems with substandard work previously completed on the inclinator.

The taxpayers engaged a third company and incurred costs including replacement of recently installed electrics in the income year following purchase. Invoices were provided for the repair to the inclinator.

The taxpayers were not expecting to incur the costs to repair the inclinator based on the work performed on the inclinator prior to purchase of the property.

In the income year following the acquisition of the property, landscaping at the front of the house moved. A geotechnical inspection to assess the damage and geotechnical advice with regards to remediation measures was sought.

An engineering geologist's inspection summary was provided dated XX/XX/20XX and outlines observations from the site visit on XX/XX/20XX and recommendations for remediation.

The Engineer's Report notes at the time of the current inspection, a shallow landslip was occurring between the retaining walls, downslope of the residence. The displaced material (debris) from the landslip was saturated and flowing over and around the two timber log retaining walls then cascading down the shotcrete.

The Engineer's Report notes the landslip is considered to have occurred as a result of saturation of the slope during a prolonged period of heavy rainfall. The report outlined options for remediation.

Email correspondence dated XX/XX/20XX and XX/XX20XX between the taxpayers and an engineering consulting firm was provided regarding the remediation options.

The work to remediate the landslip area commenced in XX/XX/20XX. Tax invoices were provided for the landslip works.

The pre-purchase Building Report dated XX/XX/20XX includes comments in relation to Site/Grounds.

Email dated XX/XX20XX to taxpayers from an engineering consulting firm regarding pre-purchase engineering assessment of site inspection on XX/XX/20XX. The email comments on the condition of existing retaining walls.

A Termite Inspection Report dated XX/XX/20XX gives advice about the condition of the property with regard to subterranean termites and outlines site conductive conditions present and included timber retaining walls.

The expenses incurred are not covered by insurance and no other payment has been received or will be received for the work undertaken.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10/p>

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 section 110-25(5)

Reasons for decision

Under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) you can claim a deduction for losses and outgoings which are incurred in the course of gaining or producing assessable income, unless the losses or 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 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 the 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.

Paragraph 38 in TR 97/23 states:

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

TR 97/23 references the expression 'initial repair' and states at paragraph 4 and paragraph 5:

4. In this Ruling, the expression 'initial repair' refers to a repair by a taxpayer that remedies some defect in property or makes good damage to, or deterioration of, property being a defect, damage or deterioration:

(a)  existing when the property was acquired from another person (whether by purchase, lease or licence); and

(b)  not arising from the operations of the taxpayer who incurs the repair expenditure.

5. A repair is not an 'initial repair' simply because it is the first repair made after property is acquired. It is an 'initial repair' if repair is due when the property is acquired in the sent that the property has defects, damage or deterioration or is not in good order and suitable in the way intended.

Paragraph 59 of TR 97/23 states:

Expenditure incurred on an initial repair after property is acquired, if the expenditure 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.This is so whether the property is purchased or obtained under lease or licence by the taxpayer. 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: but see paragraphs 63 to 66 of the Ruling in relation to dissecting or apportioning initial repair costs.

Paragraph 60 of TR 97/23 states:

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:

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

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

It is not considered material whether the taxpayer was 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 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 (paragraph 61 of TR 97/23).

Apportionment

Paragraph 55 to 57 of TR 97/23 covers repairs done at the same time as improvements. The character of a repair does not necessarily change because it is carried out at the same time as an improvement. It is necessary to examine separately the individual parts of the total project to determine whether any part, if considered in isolation, is a repair. If individual parts of the total project can be separated and characterised as repairs, and if their cost can be segregated and accurately quantified, their cost is deductible. If repair work is inextricably bound up with work of an improvement nature, and the repair work cannot be separately segregated and its cost accurately quantified independently form the cost of improvements, we regard the cost of the entire work as being of a capital nature and not deductible. It must be possible to segregate the cost of the repairs actually affected from the capital cost of the improvements.

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 2022 guide provides on page 26 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.

Subsection 43-70(2) of the ITAA 1997 lists a number of expenditures that are excluded from the definition of construction expenditure.

2) Construction expenditure does not include:

(a) expenditure on acquiring land; or

(b) expenditure on demolishing existing structures; or

(c) expenditure on clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation works; or

(d) expenditure on landscaping; or

(e) expenditure on * plant; or

(f) expenditure on property for which a deduction is allowable, or would be allowable if the property were for use for the * purpose of producing assessable income

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 purchased. 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. These elements are added together to work out the 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 considered when calculating the capital gain or loss on a CGT asset when it is disposed of in the future.

Application to the circumstances

Inclinator

Expenses were incurred in the income year following purchase to replace faulty parts and to restore the inclinator to its original function.

The work replaced and corrected parts that were already there and restored the efficiency of function of the inclinator without changing its character. We are satisfied the expenses meet the definition of 'repair' as outlined in TR 97/23. The work is not regarded as an improvement. Also, the work does not constitute a replacement of an entirety as only parts of the inclinator were replaced.

The information provided suggests the inclinator was not in good working condition at the time the property was purchased. This indicates the inclinator had defects at the date of acquisition and the defects did not occur out of normal wear and tear or damage that occurred as a result of renting out the property.

Expenses incurred to remedy defects, damage or deterioration that existed at the date the property was acquired are initial repairs which are capital in nature. 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 acquired. Therefore, no deduction is allowed under section 8-1 of the ITAA 1997 or section 25-10 of the ITAA 1997 for the cost of the repair work carried out on the inclinator.

Landscaping

During the income year following purchase of the property there was a landslip in front of the house. The landslip occurred between the second and third retaining walls. The debris from the landslip was saturated and flowed over and around the two retaining walls then cascading down the shotcrete.

From the information provided, we are satisfied the landslip was the result of prolonged and heavy rainfall after the property was acquired.

The rectification and concreting invoices provided show work included removal of an existing retaining wall and construction of a new retaining wall. Additionally, the walkway deck area behind the second bedroom was removed and replaced with a new concrete pathway and new drainage was constructed.

Retaining walls are viewed as an entirety in their own right with their own function. It is not clear from the information provided which retaining wall (or walls) was involved in the rectification works. However, it is clear at least one existing retaining wall was replaced and extended. We note, there is no information provided indicating any of the existing retaining walls were damaged in the landslip.

The replacement of the retaining wall goes beyond restoring the retaining wall to its original state. The full removal and replacement are both a renewal or reconstruction of an entirely and an improvement. Therefore, the cost of replacing an entire retaining wall with a new retaining wall is of a capital nature.

Based on the information provided there is a possibility the defect, damage or deterioration to the retaining wall existed at the date the taxpayers acquired the property.

The concrete pathway and new drainage will have the effect of minimising future stormwater from saturating the slope and causing instability and slope movement. The work provides a greater efficiency of function in the property. Therefore, the work is considered an improvement and therefore not an allowable deduction as a repair.

It appears some of the rectification work related to landscaping such as removing material and debris and revegetation of the landslip area. Generally, the associated expenses would be deductible as repairs under section 25-10 of the ITAA 1997 if the work carried out returned the area to its original condition. As mentioned previously, the character of a repair does not change because it is carried out at the same time as an improvement.

However, it must be possible to segregate, characterise and quantify the cost of repairs actually affected from the capital cost of the improvements. Because the repair work is inextricably bound up with work of an improvement nature, and the repair work is not separated and the cost quantified from the cost of improvements, we regard the cost of the entire work as being of a capital nature.

Therefore, the entire expenses totalling $XX,XXX are not deductible as a repair under section 8-1 of the ITAA 1997 and section 25-10 of the ITAA 1997 because they are capital expenditure.

While an immediate deduction cannot be claimed for repairs, a capital works deduction may be available under Division 43 of the ITAA 1997 for any construction expenditure that is not excluded under subsection 43-70(2) of the ITAA 1997.

If those expenses are not deductible under Division 43 of the ITAA 1997, then they may be included in the cost base of the property.

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).