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Edited version of your private ruling
Authorisation Number: 1012573931767
Ruling
Subject: legal expenses
Questions
1. Are legal fees incurred in relation to your investment property deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
No.
2. Are legal fees incurred in relation to your investment property included in the cost base for capital gains tax purposes?
Answer
Yes.
This ruling applies for the following period(s)
Year ended 30 June 2012
The scheme commences on
1 July 2011
Relevant facts and circumstances
You entered into a contract to have an investment property built in a display village. Once built, the property was to be leased back to the builder as a display home.
The builder went bankrupt and the investment property was not completed as per the contract.
You approached the builder's insurance company; however the insurance company would not build the home as per the specifications in the contract.
You sought legal advice and your legal team approached the insurance company and, ultimately, the investment property was to be built as per the original contract.
In addition, the local council would not allow the display home to be used as a residential rental property because the property was built in a display village.
Your legal team also approached the council and as a result, the property can be used as a residential rental property.
You have incurred legal expenses.
Relevant legislative provisions
Income Tax Assessment Act 1997 - Section 8-1
Reasons for decision
Section 8-1 of the 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.
In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190, the Court established that in determining whether a deduction is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered. The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses. Dixon J stated at CLR 647 that:
...legal expenses...take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purposes of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.
If the advantage to be gained is of a capital nature then the expenses incurred in gaining the advantage will also be of a capital nature.
In your case, you have incurred legal expenses in relation to the construction of a rental property, a capital asset, and are capital in nature. You have also incurred legal expenses to ensure the property could be used as a residential rental property. These expenses are also considered to be capital in nature, as they were incurred to preserve the value of the property as an investment property.
As the nature or character of legal expenses follows the advantage that is sought to be gained by incurring the expenses, the expenses you have incurred are considered to be of a capital nature and are not deductible under section 8-1 of the ITAA 1997.
However, these expenses can be included in the cost base when calculating any capital gain from the sale of the property.
Capital gains tax
The cost base of a capital gains tax (CGT) asset consists of five elements:
o The first element, being the acquisition costs, is the total of the money paid, or required to be paid, in respect of the acquisition.
o The second element is the incidental costs that the taxpayer incurs in acquiring the asset of which relate to a CGT event that happens in relation to the asset.
o The third element is costs of ownership, including both capital and non-capital costs.
o The fourth element is capital costs associated with increasing or preserving the value of your asset, or installing or moving the asset.
o The fifth element is capital expenditure incurred by a taxpayer in establishing, preserving or defending their title to an asset, or right over an asset.
In your case, the legal expenses incurred in relation to the construction of the property should be included in the second element of the cost base, and the expenses incurred in relation to preserving the property's value as an investment property should be included in the fourth element when calculating any capital gain from the sale of the property.