Edited version of private advice

Authorisation Number: 1052239197989

Date of advice: 11 April 2024

Ruling

Subject: Rental property - deductions

Question 1

Are you entitled to claim an immediate deduction for repairs relating to your rental property?

Answer

No.

Question 2

Are you entitled to a capital works deduction for work carried out on the bathroom at your rental property?

Answer

Yes.

Question 3

Are you entitled to a deduction for the decline in value for work carried out on the bathroom at your rental property?

Answer

Yes.

Question 4

Are you entitled to claim an environmental protection deduction for the removal and disposal of asbestos from the wall linings to the righthand side of the rear door at your rental property?

Answer

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 a property in 20XX.

The house on this property was built in 19XX.

The property was your main residence from 20XX until the end of 20XX.

The property was made available for lease and rented out from the end of 20XX until 20XX.

The property became your main residence again in 20XX until 20XX.

You listed the property for lease again in 20XX and has been rented out with no private usage.

The bathroom condition had deteriorated while being rented out and needed general maintenance and the external cladding attached to the bathroom and laundry room became weathered.

You were initially repairing the bathroom vanities and fixing the mould issue.

You engaged the services of a builder in 20XX.

Once the repairs began, the builder informed you that the framework did not meet building standards and asbestos was discovered in the wall linings to the side of the rear door.

The builder engaged the services of a company to remove and dispose of the asbestos.

The bathroom was demolished, and all fittings and fixtures, including walls and floors, were replaced.

The exterior structure cladding was replaced.

You provided a copy of the quote from the builder for $XX,XXX, with the following inclusions:

Bathroom works

•        Strip out and remove all bathroom fittings and fixtures

•        New water-resistant plasterboard linings

•        Water proofing where required

•        Supply, relocate and install new UPVC window above toilet

•        Supply and install new walk-in shower with glass screen

•        New tiles to floor, shower area and splash back

•        Supply and install new mirrored cupboard above vanity

•        Supply and install new bathroom fittings and fixtures

•        All plumbing works associated with upgrade

•        Electrical works associated with upgrade to bathroom area only

•        Install new cavity sliding door unit

•        Painting to complete bathroom

Exterior works

•        Remove existing wall linings and replace with Axon cladding or similar

•        Painting of external wall linings that were replaced

Quote exclusions:

•        Statutory fees, consultancy, and charges.

•        Weekend or after hours works.

•        Removal of asbestos if found.

•        Anything not listed in above inclusions.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 section 40-755

Income Tax Assessment Act 1997 Division 43

Taxation Ruling TR 97/23

Taxation Ruling TR 2020/2

Taxation Ruling TR 2022/1

Reasons for decision

Summary

Based on the information provided to the Commissioner the expenses you incurred on your rental property are not deductible as repairs under section 25-10 of the ITAA 1997.

However, a deduction is available for the expenses listed in the quote from the builder under section 43-10 of the ITAA 1997 which provides a deduction for capital expenditure on capital works used to produce assessable income.

Detailed reasoning

Under section 8-1 of the ITAA 1997, you can deduct 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.

Application to your situation

Question 1

Repairs

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises used for income producing purposes, to the extent that the expenditure is not capital in nature.

Taxation Ruling TR 97/23 Income tax: deductions for repairs explains the circumstances in which deductions for repairs are allowable. Paragraph 21 provides, a repair for the purposes of section 25-10 is a question of fact and degree in each case having regard to the appearance, form, state, and condition of the particular property at the time the expenditure is incurred and to the nature and extent of the work done to the property. The ruling also provides that repairs mean the remedying or making good of defects in, damage to, or deterioration of, property.

The word 'repairs' is not defined in the legislation so takes its ordinary meaning. A repair ordinarily means the remedying or making of good of defects in, damage to, or deterioration of, property to be repaired. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated.

Expenditure incurred for repairs is not deductible under section 25-10 if the expenditure 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';

•        the thing or structure is brought into a more valuable or desirable form when an initial repair would do.

Paragraph 123 of TR 97/23 provides that a repair restores the efficiency of function of the property without changing its character not whether the same material as the original is used. An improvement, on the other hand, provides a greater efficiency of function in the property. It involves bringing a thing or structure into a more valuable or desirable state or condition than a mere repair would do.

Renewal or replacement

Buckley LJ in Lurcott v Wakely & Wheeler [1911] 1 KB 905 at 924, in paragraph 113 of TR 97/23 provides:

'Repair is restoration by renewal or replacement of subsidiary parts of a whole. Renewal, as distinguished from repair, is reconstruction of the entirety, meaning by the entirety not necessarily the whole but substantially the whole subject-matter under discussion ... the question of repair is in every case one of degree, and the test is whether the act to be done is one which in substance is the renewal or replacement of defective parts, or the renewal or replacement of substantially the whole.'

TR 97/23 provides that to repair property improves to some extent the condition it was in immediately before repair. A minor and incidental degree of improvement, addition or alteration may be done to property and still be a repair. However, if the work amounts to a substantial improvement, addition, or alteration, it is not a repair and is not deductible under section 25-10.

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.

Entirety

The term 'entirety' is used by the court 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, it:

•        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.

In Case W77 89 ATC 698; (1989) 20 ATR 3888 the owner of a rental property was denied a deduction for a remodelling of a bathroom, amongst other expenditure, where repair was needed because of age, deterioration and general wear and tear. It was held that the work done in remodelling the bathroom was extensive and could be described as a complete renovation designed to improve the unit rather than simply to restore it.

In your case, the works carried out to the bathroom were extensive and can be described as a complete renovation. Although you advised that initially the work was carried out in order to remedy general wear and tear from tenants, the contract to 'repair' the bathroom was in fact a demolition and rebuild of the bathroom and exterior bathroom walls, at a cost of $XX,XXX and as such amounted to a substantial improvement. Therefore, the expenditure is capital in nature and is not a deductible 'repair' under section 25-10 or section 8-1.

Question 2

Capital works

Substantial renovations of a rental property are renovations in which all or substantially all, of a building is removed or is replaced. This could include the removal or replacement of foundations, external walls, interior supporting walls, floors, roof, or staircases.

We take into account renovations you make collectively to a house, such as the:

•        removal and replacement of the exterior walls

•        removal of some internal walls

•        replacement of the flooring

•        replacement of the bathroom.

Apart from the cost of replacing depreciating assets, the cost of the renovations will be deductible as capital works regardless of whether they are substantial.

Division 43 of the ITAA 1997 provides a deduction for capital works attributable to a construction expenditure area that is owned or leased by the taxpayer and used during the income year for the purposes of producing assessable income. Capital works includes buildings and structural improvements and also extensions, alterations or improvements to buildings and structural improvements.

Based on the fact that your property is approximately 104 years old, the 'before' and 'after' photos and the information you provided, the demolition and rebuild of the bathroom and replacement of all fittings and fixtures with their modern equivalent resulted in a dramatic change in the appearance of the room. It is considered that the work done will most likely significantly enhance the property's income producing ability, market value and saleability.

Although the work to your bathroom was carried out in order to remedy general wear and tear from tenants, it is considered the overall work carried out has gone beyond a mere repair and is more in the nature of an improvement.

As a result, all of the bathroom and exterior works listed in the quote from the builder totalling $XX,XXX the capital works expenditure under section 43-10, which provides a deduction for capital expenditure on capital works used to produce assessable income.

Subsection 43-25(1) provides that the rate of deduction for capital works that began after 26 February 1992 for a residential rental property is 2.5%, per year, spread over 40 years.

Question 3

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) 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) provides that Division 40 does not apply to capital works to the extent that an amount is or could have been deductible under Division 43.

Subsection 40-80(2) provides an immediate deduction for certain non-business depreciating assets costing $300 or less; it is used mainly for the purpose of producing assessable income; it is not part of a set of assets that cost more than $300; and it is not one of a number of identical or substantially identical assets which together cost more than $300.

The cost of replacing depreciating assets as part of substantial renovations, can be claimed as a decline in value deduction, provided the asset has been acquired as a new asset for the purpose of gaining income from rental income.

Based on the post renovation photos you provided, the original bathroom light fitting was replaced with a heat light which is a depreciative asset with an effective life of 10 years, as indicated in TR 2022/1 Income Tax: effective life of depreciating assets.

Question 4

Environmental protection

TR 2020/2 Income tax: Deductions for expenditure on environmental protection activities states that you cannot claim an environmental protection deduction for capital expenditure incurred in constructing a building, structure, or structural improvement, however, the exclusion does not apply where the replacement of a pollutant material with a non-pollutant material results in a minor or incidental degree of improvement to a building or structure.

Subsection 40-755 (1) allows an immediate deduction for expenditure you incur for the sole or dominant purpose of carrying on environmental protection activities.

Paragraphs 89 to 93 of TR 2020/2 provides the following example:

James owns a residential rental property from which he derives rental income. He engagedan asbestos surveyor who informed him that the walls were asbestos sheeting, which is a pollutant material.

James engaged a building contractor to remove the asbestos sheeting and re-sheet the walls with replacement material that was safe but of a similar condition and quality. The total cost of the work was quoted as $30,000.

The scope of the environmental protection activities will include all deeds or actions which are necessary to remedy the asbestos pollution. This will involve the removal of the asbestos walls and their replacement with a safer similar material.

The replacement sheeting of similar quality is not a capital improvement under Division 43 since it is a minor or incidental degree of alteration or improvement. Therefore, the cost of replacing the asbestos sheeting is not excluded under section 40-760.

The entire $30,000 cost is deductible under section 40-755 since this is expenditure which can be identified and specifically allocated to an environmental protection activity (that is, remedying pollution from the site of James' earning activity) and therefore satisfies the sole or dominant purpose test.

In your case the builder found asbestos in the bathroom wall, and they engaged the services of XXX to remove and dispose of the asbestos. You advised the wall was re-clad with like for like materials therefore, you are entitled to a deduction for expenditure you incurred under section 40-755 for the purpose of carrying on environmental protection activities.

Note: If any expenses claimed as a deduction have been covered by insurance claims, these claims would no longer be allowable deductions to the extent that they have been 'reimbursed'. You may need to do an amendment and an adjustment balance in your return if this occurs after lodgement.

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