Edited version of your written advice

Authorisation Number: 1012670535407

Ruling

Subject: Rental expenses

Question 1

Are you entitled to a deduction for the repairs to your rental property under section 25-10 of the Income Tax Assessment Act 1997?

Answer

No.

Question 2

Are you entitled to a deduction for legal expenses incurred in relation to your investment property defects under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ending 30 June 2015

The scheme commences on:

The scheme has commenced

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.

You purchased an investment property and settlement occurred in mid-200X.

After settlement, the property was tenanted immediately at full market rate. There were no apparent faults in the building.

Extensive renovations had been undertaken by the previous owners and completed in early 200Y.

In early 200Z, the tenants noticed faults with the construction and rapid deterioration in some parts of the property. These included:

• leaking balconies

• Leaking balconies contributed to water damage in the rooms below

• Leaking windows causing further damage to rooms

You commenced legal proceedings against the builder who completed the renovations prior to your purchase. You wanted the builder to rectify the faults.

You won the right to have the builder complete all necessary repairs. However, the builder has since been declared bankrupt.

You will have to incur all costs with no compensation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 25-10.

Reasons for decision

Summary

The repairs are required to rectify defects from the renovation which took place before you purchased the investment property. Therefore they are initial repairs and you are not entitled to an immediate deduction under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997).

Your legal expenses have been incurred in an action you have taken to have defects in existence at the time of purchase, rectified. Therefore, the costs you incurred for legal expenses are not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Repairs

Section 25-10 of the ITAA 1997 states that expenditure incurred by you for repairs to any premises, or part of premises, plant, machinery, tools or articles held or used by you solely for the purpose of producing assessable income is an allowable deduction. However, a deduction is not allowable if the expenditure is of a capital nature, for example, an improvement.

Taxation Ruling TR 97/23 provides the Tax Office's view on expenditure that is allowable under section 25-10 of the ITAA 1997.

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.

Consequently, what is considered to be a repair for the purposes of section 25-10 of the ITAA 1997 is determined by the facts of each case.

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...

Initial repairs

Initial repairs relate to the remedying of defects, damage or deterioration to a property that existed at the time of acquisition and did not arise from the operations of the taxpayer who incurs the repair expenditure (paragraph 4 Taxation Ruling TR 97/23).

Taxation Ruling TR 97/23 at paragraph 59, confirms that expenditure incurred on initial repairs is capital expenditure and is, therefore, not deductible under section 25-10 of the ITAA 1997. This paragraph also states that the cost of effecting initial repairs is still not allowable even if some income has been earned before the repair expenditure is incurred. In other words, the character of initial repairs is not altered because income is derived from the property before the expenses are incurred on the initial repairs.

Furthermore, it is immaterial whether or not you were aware of the need for the repairs at the time of acquisition or if the purchase price reflected the need for repairs (paragraphs 5 and 59-61 of Taxation Ruling TR 97/23; Law Shipping Co Ltd v Commissioners of Inland Revenue (1923) 12 TC 621 and W. Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58; 14 ATD 78; (1965) 9 AITR 710).

Initial repair costs can be dissected or apportioned

An initial repair expense can be dissected or apportioned to allow a deduction under section 25-10 of the ITAA of any part of the expense that remedies deterioration arising from the holding the property for income purposes after it was acquired.

If repair costs are attributable either to damage before property is acquired by a taxpayer or to defects that emerged suddenly and matured by the time of acquisition of the property, no deduction is allowable under section 25-10 in accordance with paragraph 59 of this Ruling. If repair costs are attributable either to damage that occurs during the taxpayer's holding. For example; of the property for income purposes or to defects that emerge suddenly and mature during that time, a deduction is allowable if the other general principles stated in this TR 97/23 are satisfied.

For further information on the methods of apportionment refer to paragraph 65 of TR 97/23 which is available of the Australian Taxation Office website at www.ato.gov.au

In your case, extensive renovations were undertaken prior to you purchasing the investment property. The tenants noticed defects in the renovations and you commenced legal proceedings so that the builder would rectify the faults.

This damage did not occur at a time you held or used the property for an income producing purpose. As such the work to rectify the faults is an initial repair and the cost involved is capital expenditure.

Therefore, you are not entitled to a deduction under section 25-10 of the ITAA 1997 for repairs of your rental property.

Legal expenses

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 where the outgoings are of a capital, private or domestic nature, or related to the earning of exempt income.

In determining whether a deduction is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; 8ATD 190; 3AITR 436 per Dixon J). The nature or character of legal expenses follows the advantage which is sought to be gained by incurring the expenses.

Where legal expenses arise as a consequence of the day to day activities of an income earning pursuit, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; ATD 87; (1938) 1 AITR 403).

In your case, you purchased an investment property in mid 200X and immediately put in a tenant. The property had been renovated in early 200Y. At the beginning of 200Z, the tenants started to notice faults with the construction and rapid deterioration in some parts of the property. You commenced legal proceedings against the builder who had completed the property renovations for the previous owner. The legal proceedings were to have the builder rectify the works in order to get them to their initial state when the property was purchased.

You won the right to have the builder complete all necessary repairs but the builder has since gone bankrupt. You will incur the repair costs with no compensation.

Your legal expenses have been incurred in an action you have taken to have defects in existence at the time of purchase, rectified. The expenditure incurred in remedying the defects, or recovering costs to remedy them, is expenditure of a capital nature.

Therefore, the costs you incurred for legal expenses is not deductible under section 8-1 of the ITAA 1997.

Additional information

Although the legal expenses are not deductible they may be included in the cost base of your property for the purposes of capital gains tax and used to calculate the capital gain or loss arising on disposal of the property.

The cost base of a CGT asset consists of five elements. The fourth element includes capital expenditure you incurred, the purpose or the expected effect of which, is to increase or preserve the assets value (paragraph 110-25(5)(a) of the ITAA 1997).