Edited version of private ruling

Authorisation Number: 1011653182178

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Ruling

Subject: Capital expenditure

Are the expenses you incurred to convert your garage into a living space for rent deductible against ordinary income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No.

This ruling applies for the following period:

Year ending 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You have a friend who was without a home, and suffering from an illness.

Your friend approached you to ask if you would convert your garage into a living space for them in return for rent.

Your garage has asbestos.

Your friend's immediate need outweighed their concerns relating to the asbestos.

You converted the garage incurring expenditure for the following items:

· stabilise asbestos

· weatherproofing of walls, ceilings, floors

· paint and insulation

· installation of windows/door by licensed asbestos approved builder

· installation of kitchen and associated water lines

· construction of bathroom, installation of shower, toilet and associated water lines, and

· purchase and connection of hot water system.

Your friend occupied the living space in the 2009-10 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 Section 43-10

Income Tax Assessment Act 1997 Section 43-15

Income Tax Assessment Act 1997 Subsection 40-45(2)

Income Tax Assessment Act 1997 Section 43-140.

Reasons for decision

Detailed reasoning

The general deduction provision can be found in section 8-1 of the ITAA 1997. These provisions allow a deduction for expenditure incurred in gaining or producing assessable income except where it is of a capital nature, private or domestic nature or relates to the earning of exempt income.

A deduction for expenditure incurred for repairs to property used to produce assessable income is specifically allowed under section 25-10 of the ITAA 1997. However, as with section 8-1 of the ITAA 1997, the expenses must not be capital in nature. Work done to property used to produce assessable income that constitutes an improvement rather than a repair is capital in nature.

Capital versus revenue expense

It is often difficult to work out what is capital expenditure and what is revenue expenditure (or repairs).

The leading case on this subject is Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403, where Dixon J said that there were three matters to be considered on this issue:

· the character of the advantage sought

· the manner in which it is to be used, relied upon or enjoyed, and

· the means adopted to obtain it.

The first two elements consider whether the outgoing has provided a lasting or recurrent advantage. An expense will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205).

Revenue expenditure, or money spent on repairs, is often repetitious or recurring in nature and often does not produce assets or advantages of an enduring nature.

The third element refers to whether the payment is frequent or a one off. A one off payment is more likely to be capital in nature. Revenue expenses tend to be recurrent payments.

The word 'repair' is not defined within the tax legislation. Accordingly, it takes its ordinary meaning. 'Repair' involves a restoration of a thing to a condition it formerly had without changing its character (W Thomas & Co v. Federal Commissioner of Taxation (1965) 115 CLR 58; (1965) 14 ATD 78; (1965) 9 AITR 710).

Taxation Ruling TR 97/23 discusses deductions for repairs. According to paragraph 15 of TR 97/23, a repair merely replaces a part of something or corrects something that is already to repair is to make good damage or deterioration that has occurred by ordinary wear and tear, by accidental or deliberate damage or by the operation of natural causes (whether expected or unexpected) during the passage of time. Repairing property to some extent improves the condition it was in immediately before the repair.

In your case, the expenditure you incurred for converting your garage into living space, did not restore or correct something to its former appearance, form state or condition. It was not spent to "make good' damage or deterioration that had occurred by ordinary wear and tear or deliberate damage or by natural causes. The expenditure you incurred in converting the garage into a living space was therefore capital in nature and therefore not deductible against ordinary income under section 8-1 of the ITAA 1997.

Further issues for you to consider

Depreciating assets

Where expenditure in relation to a rental property is capital in nature and therefore not allowable as an outright deduction under sections 8-1 or 25-10 of the ITAA 1997, a deduction may be available under another provision.

Under the uniform capital allowance system, Division 40 of the ITAA 1997, deductions are available for the decline in value of depreciating assets used for income producing purposes.

A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

A decline in value deduction is claimed over the effective life of a depreciating asset (including plant) used for income producing purposes. This deduction cannot be claimed where a capital works deduction for the item is allowable.

The hot water system is considered to be a depreciating asset, therefore a deduction will be available for the decline in value over its effective life under Division 40 of ITAA 1997. For further information, please see the publications Rental properties 2009-10 (NAT 1729) and Guide to depreciating assets 2009 (NAT 1996). Both of these publications can be downloaded from our website www.ato.gov.au.

Capital works deductions

Capital works is a broad term covering a range of structures including buildings, structural improvements and environmental earthworks.

The deductibility of expenditure incurred in relation to capital works is determined under Division 43 of the ITAA 1997. Subsection 40-45(2) prevents these capital works from being deductible under Division 40.

The rate of deduction is either 2.5% or 4% of the construction expenditure depending on when construction started and how the capital works are used. For capital works where construction started after 15 September 1987 the rate of deduction is 2.5% of the construction expenditure. Expenditure on plant is specifically excluded from the capital works deduction.

The issue of whether an item is plant is significant as it is relevant in determining whether a capital works deduction or a decline in value deduction is available.

It is a question of fact and degree as to whether an item forms part of the premises. The following are relevant matters to consider when determining that question:

· whether the item appears visually to retain a separate identity

· the degree of permanence with which it has been attached

· the incompleteness of the structure without it, and

· the extent to which it was intended to be permanent or whether it was likely to be replaced within a relatively short period.

A residential rental property is almost always the setting of the landlord's rental income earning activities and not within the ordinary meaning of plant. Similarly, an item that forms part of those premises is part of that setting and not within the ordinary meaning of plant.

The use test must be satisfied before a capital works deduction is available. To satisfy the use test, the capital works must actually be used in a deductible way in the income year in which the deduction is claimed.

In your case the use test has been satisfied when the building was completed and ready for your friend to occupy it, who has done so during the 2009-10 financial year. The rate of deduction available to you is 2.5% per year of your construction expenditure.

Accordingly, you are entitled to a capital works deduction for the expenditure you incurred to covert your garage into a living space, under section 43-70 of the ITAA 1997, with the exception of the hot water system identified as a depreciating asset above.

Note:

With respect to capital gains tax (CGT), expenditure on a capital improvement will form part of the cost base of a rental property if the purpose or the expected effect of the expenditure was to increase or preserve the asset's value. However, the expenditure that is included in the cost base must be reduced by the amount that you will have claimed or were entitled to claim as a capital works deduction.

Please refer to the publication Guide to capital gains tax 2009-10 (NAT 4151) for information on the cost base for CGT purposes. This publication can be downloaded from our website www.ato.gov.au.