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Ruling

Subject: Rental property expenditure

Question 1

Are you entitled to an immediate deduction for the drainage work performed at your rental property?

Answer

No.

Question 2

Are you entitled to a capital works deduction for the drainage work performed at your rental property?

Answer

No.

Question 3

Does the cost of the drainage work performed at your rental property form part of the cost base of the property for Capital Gains Tax (CGT) purposes?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You own a rental property.

After complaints from your tenants about the smell from water lying around due to flooding, you were required to carry out drainage work at your rental property.

You had drainage pits permanently put in place to collect the water that was building up as there were no storm water drains on the property.

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 43-20

Income Tax Assessment Act 1997 Subsection 110-25(5)

Reasons for decision

Summary

You are not entitled to an immediate deduction for the drainage work performed at your rental property as it is a capital expense. Also, it does not qualify for a capital works deduction but does form part of the cost base of the property for CGT purposes.

Detailed reasoning

Immediate deduction

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, or relate to the earning of exempt income.

Also, section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs made to premises or depreciating assets used for producing assessable income.

However, subsection 25-10(3) of the ITAA 1997 denies a deduction for repairs where the expenditure is of a capital nature.

An improvement to a property would be capital in nature and therefore not deductible under either section 25-10 or section 8-1 of the ITAA 1997.

Taxation Ruling TR 97/23 provides guidelines on the deductibility of repairs. Generally, a 'repair' involves a restoration of a thing to a condition and efficiency it formerly had. Works can be fairly described as repairs if they are done to make good damage or deterioration of property that has occurred by ordinary wear and tear, by accidental or deliberate damage, or by the operation of natural causes during the passage of time.

TR 97/23 provides that where the work done to a property results in a greater efficiency of function in the property the work represents an 'improvement' rather than a 'repair'.

In your case, the work undertaken was to alleviate a problem of flooding by adding drainage pits to your rental property. The work is not to repair or replace a part of something or correct something that is already in existence which has become worn out or dilapidated. The work provides a greater efficiency of function to the property as it improves the drainage of the property.

Therefore, the addition of the drainage pits is considered to be more accurately characterised as an improvement rather than a repair or maintenance. Consequently, a deduction is not allowable under either section 25-10 or section 8-1 of the ITAA 1997.

Capital works

A deduction is available under Division 43 of the ITAA 1997 for construction expenditure for certain capital works.

Section 43-20 of the ITAA 1997 recognises three categories of capital works:

· buildings or extensions, alterations or improvements to buildings;

· structural improvements or extensions, alterations or improvements to structural improvements; and

· environmental protection earthworks.

However, subsection 43-20(4) of the ITAA 1997 states:

This Division does not apply to structural improvements being:

(a) earthworks that:

· are not integral to the installation or construction of a structure; and

· are permanent (assuming they are maintained in reasonably good order and condition); and

· can be economically maintained in reasonably good order and condition for an indefinite period; for example, unlined channels, unlined basins, earth tanks and dirt tracks

Environmental protection earthworks are earthworks that deal with pollution or waste (subsection 43-20(5) and subsection 40-755(2) of the ITAA 1997).

The drainage pits that you put in to alleviate flooding in the yard of your rental property are similar to unlined channels and therefore are excluded from being a structural improvement by paragraph 43-20(4)(a) of the ITAA 1997. Also, they are not considered to be environmental protection earthworks.

Therefore, you are not entitled to a capital works deduction in relation to the drainage work.

Capital Gains Tax

Where a deduction for capital expenses is not available under Division 43 of the ITAA 1997, they may be included as part of the cost base on disposal of the property.

Under section 110-25 of the ITAA 1997, the cost base of a CGT asset consists of five elements. The fourth element as outlined in subsection 110-25(5) of the ITAA 1997 includes capital expenditure you incurred for the purpose or the expected effect of which is to increase or preserve the asset's value.

It is considered that the drainage work performed increases or preserves the value of your property. Therefore, it is a capital expense which forms part of the fourth element of the cost base of a CGT asset.