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Ruling

Subject: Insurance proceeds and damage to a rental property

Question 1

Is your share of the insurance proceeds paid to cover the cost of repairs to your rental property included in your assessable income in the income year that the related repair expenditure is claimed as a deduction?

Answer

Yes.

Question 2

Are you entitled to a deduction for your share of the cost of repairs carried out on your rental property?

Answer

Yes.

Question 3

Will a balancing adjustment amount be included in your assessable income in relation to the destruction and replacement of depreciating assets that were not allocated to the low value pool?

Answer

Yes, unless you elect to reduce the cost of the replacement assets for depreciation purposes by the balancing adjustment income amounts.

Question 4

Do you include the replacement cost of the depreciating assets that were destroyed and replaced in calculating your decline in value deduction for your low-value pool for the 2010-11 income year?

Answer

Yes.

Question 5

Will you have to take into account the insurance proceeds you received for the destruction of your depreciating assets in calculating your closing pool balance for the 2010-11 income year?

Answer

Yes.

Question 6

Will a balancing adjustment amount be included in your assessable income in relation to the destruction and replacement of depreciating assets allocated to the low value pool?

Answer

No.

Question 7

Are you entitled to claim a deduction for your share of the undeducted construction expenditure of the capital works that were destroyed?

Answer

No.

Question 8

Is your share of the insurance proceeds paid to cover the cost of reconstructing the capital works that were destroyed in the flood included in your assessable income?

Answer

No.

Question 9

Are you entitled to claim your share of capital works deductions for the replacement capital works based on the construction expenditure incurred to build those replacement capital works?

Answer

Yes.

This ruling applies for the following period

1 July 2010 to 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts and circumstances

You own a rental property as tenants in common with your spouse.

You allocate low-cost depreciating assets to a low-value pool.

Depreciating assets, such as air conditioners, that could not be allocated to the low-value pool are depreciated separately.

The property was insured under a current replacement value policy for flood damage.

The property was damaged by flood in the 2010-11 financial year.

The insurance company arranged for significant repairs and the replacement of doors, tiles, cabinets, carpet, architraves, electrical wiring, curtains, skirting boards, air conditioners, stove, oven and dishwasher. The work was completed in the 2010-11 financial year.

The insurance amounts received for the destruction of the capital works exceeded the undeducted construction expenditure for those capital works.

The insurance proceeds received for the destruction of each of your depreciating assets (termination value) not allocated to your low-value pool was more than their adjustable value.

The replacement cost of depreciating assets that had been allocated to the low-value pool did not exceed $1,000.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5,

Income Tax Assessment Act 1997 section 6-10,

Income Tax Assessment Act 1997 Subdivision 20-A,

Income Tax Assessment Act 1997 section 20-20,

Income Tax Assessment Act 1997 subsection 20-20(2),

Income Tax Assessment Act 1997 subsection 20-20(2)(b),

Income Tax Assessment Act 1997 subsection 20-25(2),

Income Tax Assessment Act 1997 subsection 20-25(5),

Income Tax Assessment Act 1997 section 25-10,

Income Tax Assessment Act 1997 subdivision 40-E,

Income Tax Assessment Act 1997 subsection 40-300(2),

Income Tax Assessment Act 1997 section 40-440,

Income Tax Assessment Act 1997 section 40-445,

Income Tax Assessment Act 1997 section 43-10,

Income Tax Assessment Act 1997 section 43-40,

Income Tax Assessment Act 1997 section 43-70,

Income Tax Assessment Act 1997 subsection 43-75(6),

Income Tax Assessment Act 1997 subsection 43-115(1),

Income Tax Assessment Act 1997 section 43-250 and

Income Tax Assessment Act 1997 section 43-255.

Reasons for decision

Summary

The taxation treatment of insurance proceeds depends on what the insurance is paid to replace. An amount paid to compensate for loss ordinarily acquires the character of that for which it is substituted.

The insurance proceeds you received to cover the cost of repairs is included in your assessable income in the 2010-11 income year; the income year that the related deductible repair expenditure is incurred (and deduction claimed).

The insurance proceeds you received to cover the cost of replacing depreciating assets not allocated to your low-value pool will be included in your assessable income unless you choose to treat the balancing adjustment amount as a reduction in the opening adjustable value of the replacement asset(s).

No balancing adjustment amount will be included in your assessable income for the insurance proceeds you received in relation to the destroyed depreciating assets that had been allocated to your low-value pool.

As the insurance amount you received for the destruction of the capital works exceeded the undeducted construction expenditure for those capital works, you are not entitled to a deduction for the undeducted construction expenditure of the destroyed capital works.

The insurance proceeds you received to cover the cost of replacing destroyed capital works is not included in your assessable income.

You are entitled to claim your share of capital works deductions for the replacement capital works.

Detailed reasoning

Insurance proceeds and repairs

An amount received by way of insurance is an assessable recoupment if it is paid to cover the cost of a deductible expense and the deduction can be claimed in the current year or in an earlier income year (subsection 20-20(2) of the Income Tax Assessment Act 1997 (ITAA 1997)). [Current year means the income year for which you are working out your assessable income and deductions].

If some other entity pays an amount for you in respect of a loss or outgoing that you incur, you are taken to receive the amount as recoupment of the loss or outgoing (subsection 20-25(2) of the ITAA 1997).

The cost of repairs to premises used for income producing purposes is deductible providing the expenditure is not of a capital nature (section 25-10 of the ITAA 1997).

You are considered to have incurred deductible repair expenditure when the insurance company paid for the repair work carried out, and as such, you are entitled to a deduction for your share of the cost of repairs to your rental property.

As you are entitled to a deduction for your share of the repair expenditure in the 2010-11 income year, and you received an amount of insurance to cover the cost of this expenditure, the insurance amount received to cover this expenditure is an assessable recoupment in the 2010-11 income year.

Insurance proceeds and depreciating assets

The insurance proceeds you received to compensate you for the cost of replacing destroyed depreciating assets, is not income from rendering personal services, income from property or income from carrying on a business. The payment was also a once and for all payment and therefore does not have an element of recurrence or regularity.

Accordingly, the insurance proceeds received as compensation for the destruction of depreciating assets is not assessable income under section 6-5 of the ITAA 1997.

Your assessable income also includes statutory income amounts which are not ordinary income but are included in assessable income by provisions about assessable income (section 6-10 of the ITAA 1997).

As noted above, certain amounts received by way of insurance, indemnity or other recoupment are assessable income if the amounts are not income under ordinary concepts or otherwise assessable (subdivision 20-A of the ITAA 1997).

However, if a balancing adjustment is required for property on which you incurred a loss or outgoing, no part of the termination value of the property is an amount you receive as recoupment of the loss or outgoing (subsection 20-25(5) of the ITAA 1997).

The termination value of a depreciating asset that is lost or destroyed is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction (item 8 in the table in subsection 40-300(2) of the ITAA 1997).

Therefore, the insurance proceeds you received for the destruction of your depreciating assets are not an assessable recoupment, as the amount you received is the termination value of the destroyed depreciating assets.

Depreciating assets allocated to a low-value pool

Subdivision 40-E of the ITAA 1997 contains a number of provisions that specifically apply to depreciating assets allocated to a low-value pool (pooled assets).

The decline in value of assets in a low-value pool is worked out under subsection 40-440(1) of the ITAA 1997, which provides:

You work out the decline in value of *depreciating assets in a low-value pool for an income year in this way:

Step 1: Work out the amount obtained by taking 18 ¾ % of the taxable use percentage of the *cost of each *low-cost asset you allocated to the pool for that year. Add those amounts.

Step 2: Add to the step 1 amount 18 ¾ % of the taxable use percentage of any amounts included in the second element of the *cost for that year of:

(a)     assets allocated to the pool for an earlier income year; and

(b)     *low-value assets allocated to the pool for the *current year.

Step 3: Add to the step 2 amount 37 ½ % of the sum of:

(a)     the closing pool balance for the previous income year; and

(b)     the taxable use percentage of the opening adjustable values of low-value assets, at the start of the income year, that you allocated to the pool for that year.

Step 4: The result is the decline in value of the *depreciating assets in the pool.

The closing pool balance of a low-value pool for an income year is calculated using the formula set out in subsection 40-440(2) of the ITAA 1997, and is the sum of:

(a) the ^*closing pool balance of the pool for the previous income year; and

(b) the taxable use percentage of the ^*costs of ^*low-cost assets you allocated to the pool for that year; and

(c) the taxable use percentage of the ^*opening adjustable values of any ^*low-value assets you allocated to the pool for that year as at the start of that year; and

(d) the taxable use percentage of any amounts included in the second element of the cost for the income year of:

(i) assets allocated to the pool for an earlier income year; and

(ii) low-value assets allocated to the pool for the ^*current year; less the decline in value of the ^*depreciating assets in the pool worked out under subsection 40-440(1) of the ITAA 1997.

When you stop holding a depreciating asset, such as when it is destroyed, a balancing adjustment event occurs (section 40-295 of the ITAA 1997).

Section 40-445 of the ITAA 1997 provides the simplified balancing adjustment rules for pooled assets under which the closing pool balance is reduced (but not below zero) by the taxable use percentage of the termination value of any asset the taxpayer ceases to hold (such as when it is destroyed).

If the taxable use percentage of the termination value exceeds the closing pool balance, the pool balance is exhausted and any excess is included in your assessable income.

If the taxable use percentage of the termination value does not exceed the closing pool balance, you may continue to deduct the pool balance attributable to the assets on which the balancing adjustment is made even though you no longer hold them.

When your depreciating assets were destroyed in the flood a balancing adjustment event happened. However, based on the information you have provided there will be no excess to include in your assessable income.

Depreciating assets not allocated to a low-value pool

For depreciating asset's not allocated to a low-value pool, the amount of the balancing adjustment is calculated by comparing the asset's termination value with its adjustable value (section 40-285 of the ITAA 1997).

The termination value of a depreciating asset that is lost or destroyed is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction (item 8 in the table in subsection 40-300(2) of the ITAA 1997.

The adjustable value of an asset at a particular time is the opening adjustable value for that year plus any second element costs for the year, less its decline in value for the year up to that time (paragraph 40-85(1)(c) of the ITAA 1997).

The opening adjustable value of a depreciating asset for an income year is its adjustable value to you at the end of the previous income year (subsection 40-85(2) of the ITAA 1997).

If the termination value of the depreciating asset is more than its adjustable value, the difference is included in your assessable income in the income year in which the balancing adjustment event occurred (paragraph 40-285(1)(b) of the ITAA 1997).

If the termination value of the depreciating asset is less than its adjustable value, the difference is deductible in the income year in which the balancing adjustment event occurred (paragraph 40-285(2)(b) of the ITAA 1997).

As the insurance proceeds received for the destruction of each of your depreciating assets (termination value) was more than their adjustable value, the difference is an assessable balancing adjustment amount and is included in your assessable income.

However, where you stop holding a depreciating asset because it is destroyed you may choose whether or not to include the balancing adjustment amount in your assessable income to the extent that you chose to treat it as a reduction in the cost and/or opening adjustable value of the replacement asset (section 40-365 of the ITAA 1997).

You can only make this choice for a replacement asset if:

o you incur the expenditure on the replacement asset, or you start to hold it:

o no earlier than one year, or within a further period the Commissioner allows, before the balancing adjustment event occurred; and

o no later than one year, or within a further period the Commissioner allows, after the end of the income year in which the balancing adjustment event occurred (section 40-365 of the ITAA 1997), and

o at the end of the income year in which you incurred the expenditure on the asset, or you started to hold it, you used it, or had it installed ready for use, wholly for a taxable purpose and you can deduct an amount for it (subsection 40-365(4) of the ITAA 1997.

If you choose to include a balancing adjustment amount in your assessable income then the cost and/or opening adjustable value of the replacement depreciating assets will be their cost.

If you choose not to include a balancing adjustment amount in your assessable income the cost of the replacement depreciating assets will need to be reduced to the extent that you choose to treat the balancing adjustment amount as a reduction in the cost and/or opening adjustable value of the replacement assets.

Insurance proceeds and destroyed capital works

The insurance proceeds you received to compensate you for the loss of capital works is not income from rendering personal services, income from property or income from carrying on a business. The payment is also a once and for all payment and therefore does not have an element of recurrence or regularity.

Additionally, the insurance proceeds were received for the loss of capital works and, therefore, take on the character of those capital works. As such, the payment is capital in nature.

Accordingly, the insurance proceeds you received to compensate you for the loss of capital works is not assessable income under section 6-5 of the ITAA 1997.

As noted above, your assessable income also includes statutory income amounts which are not ordinary income but are included in assessable income by provisions about assessable income (section 6-10 of the ITAA 1997).

Under paragraph 20-20(2)(b) of the ITAA 1997, recoupment of a loss or outgoing is only an assessable recoupment if the taxpayer can deduct an amount for the loss or outgoing for the current year, or has deducted or is able to deduct an amount for it for an earlier income year, under any provision of the ITAA 1997.

The phrase 'for the loss or outgoing' in paragraph 20-20(2)(b) of the ITAA 1997 requires a connection between the deduction and the loss or outgoing for which the taxpayer had been recouped (paragraph 11 of Taxation Determination TD 2006/31).

In your case, the relevant loss or outgoing which has been recouped is the destruction of the capital works. The 'loss or outgoing' referred to in paragraph 20-20(2)(b) of the ITAA 1997 is not limited to an amount expended or paid by you. As in the present case, it extends to a loss incurred as a result of the destruction of an asset.

Whilst you may have been able to deduct an amount in relation to the original construction of the capital works under section 43-40 of the ITAA 1997, or in relation to the construction of replacement capital works under section 43-10 of the ITAA 1997, these are not deductions for the loss referred to in paragraph 20-20(2)(b) of the ITAA 1997. No deduction is available for the loss of the capital works.

Accordingly, as you cannot deduct an amount for the loss or outgoing for which the insurance proceeds are received as recoupment, the insurance proceeds received for the destruction of the capital works are not an assessable recoupment under section 20-20 of the ITAA 1997.

As the insurance proceeds paid to cover the cost of reconstructing the capital works that were destroyed in the flood are not ordinary or statutory income they are not included in your assessable income under any provision of the ITAA 1997.

No deduction for destroyed capital works

o You can deduct an amount (called a balancing deduction), if all, or part of your capital works are destroyed in an income year, and:

o you have been allowed or can claim a capital works deduction for the capital works

o the capital works were used for income producing purposes before they were destroyed, and

o there is an amount of undeducted construction expenditure for the capital works (section 43-40 of the ITAA 1997).

The amount of the balancing deduction is calculated using the formula set out in section 43-250 of the ITAA 1997. Generally, the deduction is equal to the undeducted construction expenditure at the date of the destruction of the capital works less amounts you have received or have the right to receive for the destruction of the capital works, including an amount received under an insurance policy for the destruction of capital works (section 43-255 of the ITAA 1997).

As the insurance amounts received for the destruction of the capital works exceeded the undeducted construction expenditure for those capital works, the amount available as a deduction under section 43-40 of the ITAA 1997 is nil.

Deduction for new capital works

You can deduct an amount for capital works in an income year if:

o the capital works have a 'construction expenditure area'

o there is a 'pool of construction expenditure' for that area, and

o you use 'your area' in the income year to produce assessable income (section 43-10 of the ITAA 1997).

'Construction expenditure' is capital expenditure incurred in respect of the construction of capital works (subsection 43-70 of the ITAA 1997). Construction expenditure is determined on the basis of the actual costs incurred to construct the capital works, but does not include expenditure incurred to demolish existing structures.

A separate 'construction expenditure area' is created each time an entity undertakes the construction of capital works (subsection 43-75(6) of the ITAA 1997).

A 'pool of construction expenditure' is so much of the construction expenditure incurred by an entity on capital works as is attributable to the construction expenditure area.

'Your area' is the part of the construction expenditure area that you own (subsection 43-115(1) of the ITAA 1997).

'Your construction expenditure' is the portion of the pool of construction expenditure that is attributable to your area.

As construction expenditure has been incurred to build capital works and you use these capital works to produce assessable income, you are entitled to claim capital works deductions based on the total construction expenditure incurred to construct those capital works under section 43-10 of the ITAA 1997.

Further issues for you to consider

Where a taxpayer receives an amount of compensation (for example, insurance proceeds) in relation to the destruction of all, or part of an asset, there may be capital gains tax implications. You may wish to apply for a private ruling on this matter.