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Ruling

Subject: insurance proceeds and damage to rental properties

Question 1

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

Answer

Yes.

Question 2

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

Answer

Yes.

Question 3

Are you entitled to claim a deduction for the written down value of depreciating assets destroyed by the weather event?

Answer

No.

Question 4

Are you entitled to claim deductions for the decline in value of your replacement depreciating assets?

Answer

Yes; however, if you choose not to include a balancing adjustment amount in your assessable income with regards to the insurance proceeds that relate to the destroyed depreciating assets, 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.

Question 5

Are the insurance proceeds paid to cover the cost of reconstructing capital works that were destroyed in the weather event included in your assessable income?

Answer

No.

Question 6

Are you entitled to claim 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 2011 to 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

You own two rental properties.

The dwellings on the properties were constructed in the 1970's and were not eligible for capital works deductions.

Both rental properties were damaged during a weather event.

The buildings were insured.

As a result of the damage caused by the weather event and the operation of the contracts of insurance, the insurer paid for repairs to the properties, to replace destroyed depreciating assets and to reconstruct/replace destroyed capital works.

You have provided a scope of works for each property detailing the work to be undertaken to remedy the damage caused by the weather event. These scopes of work form part of the arrangement that is the subject of this ruling.

You have entered into contracts with two builders to refurbish the properties as outlined in the scopes of works. The insurer pays the builders directly for the work carried out.

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(1),

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

Income Tax Assessment Act 1997 paragraph 20-20(2)(a),

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

Income Tax Assessment Act 1997 subsection 20-20(3),

Income Tax Assessment Act 1997 subsection 20-25(1),

Income Tax Assessment Act 1997 section 25-10,

Income Tax Assessment Act 1997 section 40-25,

Income Tax Assessment Act 1997 subsection 40-25(7),

Income Tax Assessment Act 1997 subsection 40-85(2),

Income Tax Assessment Act 1997 paragraph 40-85(1)(c),

Income Tax Assessment Act 1997 section 40-285,

Income Tax Assessment Act 1997 paragraph 40-285(1)(b),

Income Tax Assessment Act 1997 paragraph 40-285(2)(b),

Income Tax Assessment Act 1997 section 40-295,

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

Income Tax Assessment Act 1997 section 40-365,

Income Tax Assessment Act 1997 subsection 40-365(4),

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) and

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

Reasons for decision

Question 1

Summary

You are entitled to a deduction for the cost of repairs carried out on your rental properties.

Detailed reasoning

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 Income Tax Assessment Act 1997 (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 under section
25-10 of the ITAA 1997 for the cost of repairs to your rental properties.

Question 2

Summary

Your assessable income includes the insurance proceeds paid to cover the cost of repairs to your rental properties.

Detailed reasoning

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 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).

As noted above, you incurred deductible repair expenditure when the insurance company paid for the repairs to your rental properties.

As you are entitled to a deduction for the cost of repairs to your rental properties, and your insurer paid to cover the cost of this expenditure, the insurance amount paid to cover this expenditure is an assessable recoupment under subsection 20-20(2) of the ITAA 1997, in the income year(s) that the related repair expenditure is claimed as a deduction.

Question 3

Summary

A balancing adjustment event occurs for a depreciating asset when it is destroyed.

Where the insurance amount received for the destruction of a depreciating asset is less than its adjustable value, you can deduct the difference.

Where the insurance amount you received for the destruction of a depreciating asset exceeds its adjustable value, the difference is included in your assessable income.

When a depreciating asset is disposed of involuntarily, such as when it is destroyed by a weather event, you may offset an assessable balancing adjustment amount arising from the involuntary disposal against the cost of a replacement asset.

Detailed reasoning

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).

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 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:

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

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

· 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

· 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).

Based on the information you have provided you meet the abovementioned conditions to make a choice whether or not to include the balancing adjustment amounts in your assessable income.

The balancing adjustment amounts will be included in your assessable income unless you choose to treat the balancing adjustment amounts as a reduction in the opening adjustable value of the replacement assets.

Question 4

Summary

You are entitled to claim deductions for the decline in value of your replacement depreciating assets. The cost of the replacement depreciating assets for decline in value purposes will depend on whether or not you chose to include a balancing adjustment amount in your assessable income as a result of the balancing adjustment event occurring for the destroyed depreciating assets.

Detailed reasoning

Section 40-25 of the ITAA 1997 allows you to deduct an amount equal to the decline in value for an income year of a depreciating asset to the extent that it is used for a taxable purpose.

A taxable purpose includes the purpose of producing assessable income (subsection 40-25(7) of the ITAA 1997).

As you use the depreciating assets in your rental properties you are entitled to claim deductions for their decline in value.

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.

Question 5

Summary

The insurance proceeds paid to cover the cost of reconstructing the capital works that were destroyed in the weather event is not included in your assessable income under any provision of the ITAA 1997.

Detailed reasoning

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997). The legislation, however, does not define the expression income according to ordinary concepts. 

Ordinary income generally includes three categories, namely, income from rendering personal services, income from property, and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

Ordinarily, an amount paid to compensate for loss acquires the character of that for which it is substituted (FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82).

The insurance proceeds paid to cover the cost of reconstructing the capital works that were destroyed in the weather event 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 paid to cover the cost of reconstructing the capital works that were destroyed in the weather event 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).

Subdivision 20-A of the ITAA 1997 provides that 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.

Subsection 20-20(1) of the ITAA 1997 provides that an amount is not an assessable recoupment to the extent that it is ordinary income, or it is statutory income because of a provision outside of Subdivision 20-A of the ITAA 1997.

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 ITAA 1997). [Current year means the income year for which you are working out your assessable income and deductions].

As the insurance proceeds are capital in nature, and there is no provision outside of Subdivision 20-A of the ITAA 1997 that specifically includes the insurance proceeds in your assessable income, subsection 20-20(1) of the ITAA 1997 does not exclude the amount from being an assessable recoupment.

In order to determine whether or not the insurance proceeds are an assessable recoupment, it must be considered whether the insurance proceeds received are a recoupment. Recoupment is a defined term and has the meaning given by subsection 20-25(1) of the ITAA 1997. Under paragraph 20-25(1)(a), a recoupment of a loss or outgoing includes any kind of insurance.

You were a party to a contract of insurance under which the insurer was bound to make a payment to you upon the happening, to the capital works, of certain events. Upon the destruction of the capital works, the insurer paid an amount on your behalf. Accordingly, the insurance proceeds are received as recoupment for the purpose of paragraph 20-25(1)(a) of the ITAA 1997, and are a recoupment for the purposes of paragraph 20-20(2)(a) of the ITAA 1997.

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).

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 considers the phrase 'for the loss or outgoing' in the context of subsection 20-20(3) of the ITAA 1997).

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. 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 weather event are not ordinary or statutory income they are not included in your assessable income under any provision of the ITAA 1997.

Question 6

Summary

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

Detailed reasoning

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

· the capital works have a 'construction expenditure area'

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

· 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.