Edited version of your written advice

Authorisation Number: 1012806943382

Ruling

Subject: Rental property - flood damage - insurance proceeds

Question 1:

Are you entitled to a deduction for your share of the interest on the loan used to purchase the rental property and council fees in the 2012-13 and 2013-14 income years?

Answer: Yes

Question 2:

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

Answer: Yes.

Question 3:

Is your share of the amount of insurance proceeds that covers the cost of repairs to the rental property included in your assessable income in the income year that the related repair expenditure is claimed as a deduction?

Answer: Yes

Question 4:

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

Answer: No.

Question 5:

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 6:

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

Answer: No.

Question 7:

Are you entitled to claim your share of capital works deductions for the part of the work on the damaged rental property that qualifies as capital works?

Answer: Yes.

Question 8:

Is your share of the insurance proceeds that exceeds the expenses incurred to rectify the damage to your rental property assessable income?

Answer: No.

This ruling applies for the following periods:

Year ended 30 June 2013
Year ended 30 June 2014

The scheme commenced on:

1 July 2012

Relevant facts

You own a rental property as a joint tenant with your spouse.

The property was constructed several decades ago and the original building is not eligible for a capital works deduction.

The property was in good condition when you and your spouse purchased it several years ago.

You and your spouse undertook some initial repairs to the property before it was made available for rent.

A couple of years ago the property suffered significant damage.

You and your spouse made a claim on your insurance policy and received amounts under the policy.

Remedial work has been completed on the property and it has been re-tenanted.

In the 2012-13 and 2013-14 income years you and your spouse paid costs for interest on a loan used to purchase the property and council rates in relation to the property.

The property was rented in the 2012-13 and 2013-14 income years.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 20-20

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

Income Tax Assessment Act 1997 paragraph 20-20(2)(b)

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Division 43

Reasons for decision

Question 1

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a deduction is allowable for expenses incurred in gaining or producing assessable income, provided those expenses are not capital, private or domestic in nature.

Generally a deduction under section 8-1 of the ITAA 1997 is allowable for certain expenses such as interest on a loan to purchase an income producing property, council and water rates, advertising, agent fees and commissions and other the revenue type expenses you incur for the period your property is rented or is available for rent.

In your case, the property had been used in the production of assessable income for the 2012-13 and 2013-14 income years in which the expenditure for the interest on the loan and council rates were incurred. Although the property was not available for rent for a period while it was damaged and while repairs were carried out, it was still being held for the purpose of producing assessable income.

Accordingly, as you jointly own the property with your spouse, you and your spouse are each entitled to claim a deduction under section 8-1 of the ITAA 1997 for half of the interest on the loan used to purchase the property and council fees in the 2012-13 and 2013-14 income years.

Question 2

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 ITAA 1997)

Repairs were carried out on your jointly owned rental property. You are entitled to a deduction under section 25-10 of the ITAA 1997 for your share of the cost of these repairs.

Question 3

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 you are entitled to a deduction for the repair expenditure in the 2012-13 and 2013-14 income years, and you received an amount of insurance to cover the cost of this expenditure, the insurance amount received that covers this expenditure is an assessable recoupment in the 2012-13 and 2013-14 income years under subsection 20-20(2) of the ITAA 1997.

Question 4

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:

• no earlier than one year, or within a further period the Commissioner allows, before the balancing adjustment event occurred; and

• 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 (the portion of the insurance proceeds to replace the assets that exceeds their adjustable value) 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 5

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.

For example, where a taxpayer holds a depreciating asset with an adjustable value of zero which is destroyed and they receive insurance proceeds to replace the asset, the balancing adjustment amount is the amount of those insurance proceeds.

The taxpayer has the option of including the balancing adjustment amount in their income tax return in the income year the insurance proceeds are received and claim a decline in value deduction over the effective life of the replacement asset where the asset is used for a taxable purpose. Or the taxpayer can choose not to include the insurance proceeds for the asset in their tax return and not claim a decline in value deduction for the replacement asset (assuming the cost of the replacement asset is equal to or less than the amount of the related insurance proceeds).

Question 6

Although the original construction expenditure for the property is not eligible for a capital works deduction, your expenditure on initial repairs undertaken when you purchased the property may qualify as eligible capital works.

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).

The information provided indicates that the insurance proceeds received for the destruction of the initial repairs at least equalled the original expenditure on the initial repairs. Therefore any capital works balancing deduction that may have been applicable for you would be reduced to nil under section 43-250 of the ITAA 1997.

Question 7

A 2.5% capital works deduction is available under Division 43 of the ITAA 1997 for construction expenditure on capital works carried out after 21 August 1979 in relation to a building used for income producing purposes.

The information you provided indicates that the remedial work undertaken after your rental property was damaged consisted of repairs, replacement of depreciating assets and capital works.

You are entitled to a capital works deduction for your share of the construction expenditure on the capital works carried out on the rental property.

Note: Your share of the insurance proceeds received for the capital works that were destroyed in the flood is not included in your assessable income. This amount is capital in nature and therefore is not ordinary income. For it to be an assessable recoupment, you must be able to claim a deduction for the loss that is being recouped. The loss in this case is the destruction of capital works. Although you are entitled to a deduction in relation to the construction of the new capital works, that is not the same as a deduction for the destruction of the previous capital works. Therefore, the amount is not an assessable recoupment.

Question 8

Summary

Your share of the excess insurance proceeds is not considered ordinary income and therefore is not included in your assessable income.

Detailed reasoning

Section 6-5 of the ITAA 1997 provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). 

Ordinary income has generally been held to include 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.

In your case, excess insurance proceeds is not income from rendering personal services, income from property or income from carrying on a business. Although the payment can be said to be expected, and perhaps relied upon, this expectation arises from an entitlement under a policy of insurance to compensate you for a loss incurred as a result of the destruction of part of an asset.

It is not considered that the excess insurance proceeds have the characteristics of ordinary income and therefore are not assessable income under section 6-5 of the ITAA 1997.

Further information

Although the excess insurance proceeds are not assessable income, they will reduce the cost base of the rental property for the purposes of calculating any capital gain when the rental property is eventually sold (see paragraphs 3, 6, 7 and 8 of TR 95/35). You may wish to apply for a private ruling on this matter at the time the property is sold.