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Ruling

Subject: legal and insurance costs

Question 1

Are you entitled to a deduction for legal and conveyancing expenses incurred in relation to an investment property where the contract was cancelled?

Answer

No.

Question 2

Are you entitled to a deduction for your share of the un-refunded building insurance where the contract was cancelled?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

In 2010 you and your partner signed a contract and paid the deposit for the purchase of an investment property.

The property was rented out and the contract was subject to the rental agreement.

You intended to maintain the existing agreement and renew the lease when it expired.

You engaged solicitors to attend to the settlement and incurred the following costs:

· insurance

· conveyancing

· solicitors fees

The vendor was unable to settle as they were unable to remove existing caveats on the property and as such the contract was cancelled. The vendor was subsequently declared bankrupt. You are unable to recover the costs from the vendor.

The landlord insurance policy covered landlord and building insurance.

You have since cancelled the insurance policy and received a partial refund.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining

assessable income or, in other words, of an income-producing expense

(Lunney v. FC of T; (1958) 100 CLR 478 (Lunney's case)),

· there must be a nexus between the outgoing and the assessable income so

that the outgoing is incidental and relevant to the gaining of assessable

income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

· it is necessary to determine the connection between the particular outgoing

and the operations or activities by which the taxpayer most directly gains or

produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v.

FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Legal costs and conveyancing costs

In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; 8 ATD 190; 3 AITR 436 per Dixon J). The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Where legal expenses arise as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Legal expenses incurred in producing rental income are incurred in gaining assessable income. However, legal expenses in relation to the purchase or sale of an investment property are capital in nature.

In your case you incurred legal expenses in relation to the purchase contract for an investment property. The legal expenses are considered to be capital in nature and therefore not an allowable deduction under section 8-1 of the ITAA 1997.

Similarly, your conveyancing fees are associated with the purchasing and subsequent cancellation of an investment property contract. As these expenses relate to a structural asset, they are considered to be capital in nature. Therefore the conveyancing fees are not an allowable deduction under section 8-1 of the ITAA 1997.

Accordingly, both your legal expenses and conveyancing costs are of a capital nature. Therefore you are not entitled to a deduction for these costs.

Insurance

Expenses incurred relating to a rental property may be deductible under section 8-1 of the ITAA 1997 if the property is rented or available for rent in the income year in which you claim the deduction. In limited circumstances a deduction may be allowable prior to the commencement of the relevant income earning activities.

Taxation Ruling TR 2004/4 considers deductions for interest expenses incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) as well as the decisions in the Full Federal Court .

While Steele's case and the ruling deal with the issue of interest, the principles can be applied to other types of expenditure such as insurance.

In Steeles case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. TR 2004/4 concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

· the interest is not incurred too soon, is not preliminary to the income earning activities, and is not a prelude to those activities,

· the interest is not private or domestic,

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost,

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

In your case, there is no evidence to show that you contemplated using the property for private or domestic purposes. It is considered that the insurance costs were incurred in the pursuit of gaining or producing assessable rental income. Therefore you are entitled to a deduction for your share of the un-refunded insurance costs.