Edited version of your private ruling

Authorisation Number: 1012463270675

Ruling

Subject: Insurance proceeds and damage to a rental property

Question 1

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

Answer

Yes.

Question 2

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 3

Are you entitled to claim a deduction for your share of the written down value of depreciating assets that were destroyed by the flood?

Answer

No.

Question 4

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

Answer

No.

Question 6

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 7

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 2012 to 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts and circumstances

You own a rental property jointly with your spouse.

The original dwelling was not eligible for capital works deductions.

Capital works deductions have been claimed in respect to construction expenditure incurred for improvements to the property including a kitchen, a bathroom and built-in wardrobes.

The property suffered significant damage when it was completely submerged by flood waters, including the destruction of capital works, as well as the destruction of depreciating assets.

You held a contract of insurance for the property, under which damage by flooding was a listed event.

As a result of the damage caused by flooding and operation of the contract of insurance, the insurance company paid for repairs to the property, to replace destroyed depreciating assets and to reconstruct destroyed capital works. The amount paid was calculated based on the current replacement value (incorporating construction materials and labour), up to the value insured, of the loss or damage to the rental property.

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

An independent insurance assessor prepared a scope of works detailing the work to be undertaken to remedy the damage caused by the flood. This scope of works forms part of the arrangement that is the subject of this ruling.

You entered into a contract with a building company to refurbish the house as outlined in the scope of works.

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 paragraph 20-25(1)(a)

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

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)

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

Income Tax Assessment Act 1997 section 43-250

Income Tax Assessment Act 1997 section 43-255

Reasons for decision

Question 1

Summary

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

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 your share of the cost of repairs to your rental property.

Question 2

Summary

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

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 property.

As you are entitled to a deduction for the repair expenditure in the relevant 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 relevant income year under subsection 20-20(2) of the ITAA 1997.

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 flood, 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, your share of 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:

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

· 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 your share of the balancing adjustment amounts in your assessable income.

Your share of the balancing adjustment amount 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 assets.

Question 4

Summary

You are entitled to claim deductions for your share of 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 property 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

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.

Detailed reasoning

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

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

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

· 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.

Question 6

Summary

Your share of the insurance proceeds paid to cover the cost of reconstructing the capital works that were destroyed in the flood 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 flood 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 flood 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 insurance company 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.

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.

Question 7

Summary

You are entitled to claim your share of 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.

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.