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Ruling

Subject: Deduction-capital works

Question 1:

Are you entitled to include the cost of re-construction of the living area of the property as part of the construction expenditure under the capital works provisions?

Answer:

No.

Question 2:

Are you entitled to include the cost of replacing the roof as part of the construction expenditure under the capital works provisions?

Answer:

No.

Question 3:

Are you entitled to include the renovation costs to:

· the lounge room

· the living room

· the entry

· the bedrooms

· the hall

· the separate water closet

· the laundry

· the bathroom

· floors

· doors

· windows

· carpets

as part of the construction expenditure under the capital works provisions?

Answer: No.

Question 4:

Are you entitled to claim your share of a capital works deduction for the original living area of the property from the date the property was rented?

Answer:

Yes.

Question 5:

Are you entitled to claim your share of a capital works deduction for the replacement of the fittings and fixtures after being replaced from insurance proceeds from the date the property was rented?

Answer:

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

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.

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· a private ruling request

· a scope of work documents

· a schedule for major building work contract for domestic buildings

· a spreadsheet for the cost of storm damage repairs

· tax invoice

You and your spouse jointly own a property which was built before the 1970s.

This property was your main residence before it was first leased out.

In an earlier financial year renovations were undertaken to the property to include a living area.

The living area is attached to the main house.

A storm caused a number of trees to fall on the property as a result causing damage to the property.

The roof of the property was replaced with a colour-bond roof.

Further work was done to the property to fix the damage as a result of a storm.

The part of the living area was restored to its original condition.

The cost of all the work undertaken to the property was covered by insurance.

After the work was completed, the property was then rented.

Relevant legislative provisions

Income Tax Assessment 1936 section 124ZG

Income Tax Assessment 1936 section 124ZH

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 subsection 25-10(3)

Income Tax Assessment Act 1997 section 43-10.

Income Tax Assessment Act 1997 section 43-20.

Income Tax Assessment Act 1997 section 43-70.

Income Tax Assessment Act 1997 subsection 43-73(3).

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

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

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

Reasons for decision

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to a rental property.

To be eligible to claim such an expense you must be holding the property for the purpose of gaining or producing assessable income, and the expenses must not be capital in nature.

Subsection 25-10 (3) of the ITAA 1997 precludes a deduction for repairs where the expenditure is of a capital nature.

Repair costs are deductible where they are incurred during the period the property is held for income producing purposes and are attributable either to damage that occurs during your income producing use of the property or to defects that emerge suddenly during that time.

Taxation Ruling TR 97/23 indicates that expenditure for repairs to property is of a capital nature where:

· the extent of the work carried out represents a renewal or reconstruction of the entirety, or

· the works result in a greater efficiency of function in the property, therefore representing an 'improvement' rather than 'repair', or

· the work is an initial repair.

The meaning of repairs

The term 'repairs' is not defined in section 25-10 of the ITAA 1997. Therefore, it is necessary to look at its ordinary meaning. Paragraph 13 of Taxation Ruling TR 97/23 states the following: 

The word 'repairs' has its ordinary meaning. It ordinarily means the remedying or making good of defects in, damage to, or deterioration of, property to be repaired (being defects, damage or deterioration in a mechanical and physical sense) and contemplates the continued existence of the property.

At paragraph 44, the ruling goes on to state:

In the case of a 'repair', broadly speaking, the work restores the efficiency of function of the property without changing its character...

Repair is distinct from renewal or replacement 
Renewal, replacement, or reconstruction of, the whole or substantially the whole of a thing or structure ('entirety') is likely to be considered a capital improvement rather than a deductible repair.

What is an entirety?
Determining what is an entirety is a question of fact in each case. According to TR 97/23, property is more likely to be an entirety if:

(a) The property is separately identifiable as a principal item of capital

equipment.

(b) The thing or structure is an integral part, but only a part, of the entire

premises and is capable of providing a useful function without regard to any

other part of the premises.

(c) The thing or structure is a separate and distinct item of plant in itself from the

thing or structure which it serves, or

(d) The thing is a 'unit of property' as that expression is used in the depreciation deduction provisions of the income tax law.

In the case of W Thomas & Co Pty Ltd v. FC of T (1965) 115 CLR 58; (1965) 14 ATD 78; (1965) 9 AITR 710 (Thomas' Case) which involved a claim for general repairs to a building, it was said that the question was not whether the roof or floor or some other part of the building, looked at in isolation, was repaired, as distinct from wholly reconstructed, but whether what was done to the floor or the roof was a repair to the building. It was held that the roof would be considered to be part of the building and the work done on the roof was a repair. This view is confirmed in TR 97/23 at paragraph 40.

Specifically paragraph 40 of TR 97/23 states:

Examples of property that constitute an entirety are a slipway on the business site of a slip proprietor and ship repairer (the Lindsay case); a spectators' grandstand in a football stadium (the Burnley FC case); a bridge giving access to the driveway of a garage ( Case B21 (1951) 2 TBRD 101); a substantially new race track ( Case D64 72 ATC 390; (1972) 18 CTBR (NS) Case 33 ); and a factory drainage system comprising an underground system of concrete stormwater drains ( Case G5 (1955) 7 TBRD 29). Examples of property that do not constitute an entirety are the insulation and lining for a cool room ( Case T14 (1968) 18 TBRD 67) and a window in a factory (even though the window is totally restored). Something that is part of a building, e.g., a roof or wall, is just that and no more. The building itself is the entirety.

In Lindsay v. Federal Commissioner of Taxation (1961) 106 C.L.R. 377, the High Court took the view that what was carried out was the construction of 'a very substantial erection', such that it constituted a 'renewal', rather than a 'repair' in the sense spoken of by Buckley L.J. in Lurcott v. Wakely & Wheeler (1911) 1 K.B. 905 (Lurcott v Wakely and Wheeler case ) at p. 924 when he said:

Repair is restoration by renewal or replacement of subsidiary parts of the whole. Renewal, as distinguished from repair, is reconstruction of the entirety, meaning by the entirety not necessarily the whole but substantially the whole subject matter under discussion. 

TR 97/23 also states it is a question of fact and degree whether the work is the reconstruction of an entirety or a progressive restoration of subsidiary parts of the entirety over a period of time (paragraph 43). Relevant considerations in drawing the line of demarcation here include:

· the nature, scale and dimensions of the work in proportion to the nature, scale and dimensions of the property involved (the larger the work in comparison with the scale and dimensions of the property, the more likely a reconstruction of the entirety is involved);

· the period of time over which the work is done (the shorter the period, the more likely a reconstruction of the entirety is involved); and

· whether the work is done in accordance with an on-going program of restoration (more likely to constitute deductible repairs) or done in one operation (more likely to constitute non-deductible repairs).

Improvement or repair

When work is done to restore or 'fix' a damaged item, we need to determine if the work undertaken is a 'repair' or an 'improvement'. Repairs generally restore the item to its former function and efficiency whereas improvements increase an item's functionality and/or efficiency.

A repair may increase the items efficiency slightly and still be classed as a repair. However, where the item's function or efficiency is improved substantially or the work changes the function of the item, the work is considered to be an improvement and capital in nature.

Application of the above to your situation 

Re-construction of the living area

In your case, the living area is attached to the existing property and is considered an extension. The living is a separately identifiable capital item with its own function; that is, to provide an outdoor recreational area separate from the existing house and is, considered to be an entirety in itself.

In Lurcott v Wakely and Wheeler case Lord Justice Flectcher Moulton in discussing repairs stated:

For my own part, when the word "repair" is applied to a complex matter like a house, I have no doubt that the repair includes the replacement of parts. Of course, if a house had tumbled down, or was down, the word "repair" could not be used to cover rebuilding. It would not be apt to describe such an operation. But, so long as the house exists as a structure, the question whether repair means replacement, or, to use the phrase so common in marine cases, substituting new for old, does not seem to me to be at all material.

A review of the scope of work supplied for the living area indicates that the original foundations, the bearers and floor joists were not renewed or replaced as a result of the storm.

The removal and replacement of the top section of the living area is not considered an initial repair. While the work involved is quite large, the work was done as part of the restoration program as a result of the storm damage. The work does not go beyond a repair as it only replaces and rectified the damage caused by the storm as the items were replaced with their modern equivalent and restored the living area to its original function as a recreational area. The restoration work undertaken to the living area is not a renewal or reconstruction of the entirety but a repair.

Replacing the roof
In Case 51 (1960) 9 CTBR (NS) 328 it was held the replacement of a galvanised iron roof with concrete roof tiles was a repair as it did little more than meet a need for restoration. The material in question was designed to perform substantially the same function as that which it replaced.

A review of the information indicates the removal and replacement of the damaged roof is not considered an initial repair or a renewal or reconstruction of the entirety as the existing roof is a part of the dwelling built on the property. In addition the work carried out is not considered an improvement and therefore the cost of replacing the roof is not of a capital nature.

It is accepted the use of different material to replace the existing roofing material constitutes a repair as the change in material did not improve the efficiency or function of the property. The work undertaken on the roof indicates the roof has merely been repaired by its modern equivalent and restored the original function.

Fixtures and fittings

These items are considered separately identifiable capital items with their own function and are an entirety in themselves. The replacement of these items is a renewal of an entirety and the expenditure capital in nature.

Work undertaken to other areas of the property

A review of the work undertaken as per the scope of work documents provided indicates that the items that were replaced have been repaired by their modern equivalent and restored to their original function; therefore, the work is not considered an initial repair or an improvement and not capital in nature. While the extent of the work is considerable it is not considered a renewal or a substantial renewal of an entirety as the whole house is the entirety as noted in Thomas's Case above.

In summary after taking into consideration the Commissioner's views in TR 97/23, the work undertaken to the living area and the other areas of the property is considered a repair, generally the costs is deductible when the property is available for rent or rented out. However, in your case as the property was not income producing when the work was carried out, and no deduction is available under section 25-10 of the ITAA 1997.

In regards to the replacement of the fixtures and fittings these are the capital in nature and should be considered under the capital works provisions.

Capital works

For income tax years prior to the 1996-97 income tax year section 124ZG to 124ZH of the Income Tax Assessment 1936 provides for a deduction of buildings and improvements. For the 1998 and later years income tax years Division 43 of the ITAA 1997 a taxpayer can claim a deduction for capital expenditure incurred in constructing capital works, including buildings and structural improvements. Although ITAA 1997 has been re-written in relation to the former legislation, the ideas and principles are not to be taken differently just because different words are used.

The following rules apply for residential rental properties:

· If construction of the building started before 17 July 1985, special building write-off cannot be claimed

· If construction of the building started between 18 July 1985 and 15 September 1987, the annual special building write-off allowable is 4 per cent of the construction expenditure

· If construction of the building started after 15 September 1987, the annual special building write-off allowable is 2.5 per cent of the construction expenditure.

The building of an extension, alteration or improvements to an existing property and the construction of a new dwelling qualify as capital works under section 43-20 of the ITAA 1997.

The deduction is available on the cost of constructing structural improvements or extensions, alterations or improvements to structural improvements if construction started after 26 February 1992. The rate allowable is 2.5 per cent of the construction expenditure for a period of 40 years. Construction expenditure is the actual cost of constructing the capital works.

You can only claim the deduction for the period the property is rented or is available for rent.

In your case, as the original property was constructed before 17 July 1985 and there is no special building write-off that can be claimed in relation to this part of the property. However, as the living area is considered an extension to the existing property you are entitled to claim a deduction for the undeducted construction expenditure of the original living area under section 43-40 of the ITAA 1997. However, you must reduce the deduction for the period of time the property was not available for rent as any associated capital work deduction before this period is forgone.

The fixtures and fittings

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 replace the fixtures and fittings 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 for the replacement of these items under section 43-10 of the ITAA 1997.