Edited version of your written advice

Authorisation Number: 1013012812826

Date of advice: 12 May 2016

Ruling

Subject: Rental property

Question 1

Did capital gains tax event C1 happen to your rental property, or any part of the property, due to the fire?

Answer

No.

Question 2

Is the portion of the insurance proceeds that relates to the deductible repairs to your rental property included in your assessable income as an assessable recoupment?

Answer

Yes.

Question 3

Are the insurance proceeds received for capital works destroyed in the fire included in your assessable income?

Answer

No.

Question 4

Will balancing adjustment amounts be included in your assessable income in respect to depreciating assets that were destroyed in the fire, where the insurance amount received for the destruction of the asset exceeds its adjustable value?

Answer

Yes, unless you elect to reduce the cost of the replacement assets for depreciation purposes.

Question 5

Are you entitled to a deduction for the cost of repairs to your rental property following the fire?

Answer

Yes.

Question 6

Are you entitled to claim a deduction equal to 2.5% of the cost of capital works carried out?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts

Your rental property was damaged by fire.

You received an insurance payout.

Work was required following the fire.

The structural work was completed in the relevant financial year.

The works included replacing the kitchen.

Only the bathroom mirror and vanity were replaced. The shower/bath and tiles stayed the same.

The blinds, carpet and linoleum were completed in the subsequent financial year.

The property is rented again.

The property was originally constructed before 1985.

The depreciating assets in the property were fully depreciated before the fire.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-25

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

Loss or destruction of CGT assets

Capital gains tax (CGT) event C1 happens if a CGT asset you own is lost or destroyed (subsection 104-20(1) of the Income Tax Assessment Act 1997 (ITAA 1997).

Neither of the words 'lost' or 'destroyed', in the context of CGT event C1, contemplates damage to an asset that does not amount to the asset being lost or destroyed. A CGT asset must be wholly lost, or wholly destroyed, not just damaged for the circumstances to be covered by CGT event C1. This is not to say, however, that CGT event C1 cannot happen to a discrete and identifiable part of a CGT asset, being a CGT asset in its own right, if the part is wholly lost or wholly destroyed and not just damaged.

In your case, it is not considered that a discrete and identifiable part of your rental property was lost or destroyed in the fire. Rather the property was damaged. Therefore CGT event C1 has not occurred.

Assessable recoupment

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).

In your case, part of the insurance was paid to cover the cost of repairs to your rental property. Insurance proceeds were also received in relation to capital works and depreciating assets.

As you are entitled to a deduction for the repair expenditure in the relevant financial year (see below for further details), 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 financial year under subsection 20-20(2) of the ITAA 1997.

However it is not considered that all the work carried out on your rental property is a deductible repair. Please see below for further details.

Insurance proceeds and capital works

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.

In your case, some of the relevant loss or outgoing which has been recouped relates to capital works. Capital works expenditure is generally deductible over 40 years (please see below for further details).

Capital works deductions are not deductions for the loss referred to in paragraph 20-20(2)(b) of the ITAA 1997.

Accordingly, as you cannot deduct an amount for the loss or outgoing for which the relevant portion of insurance proceeds will be received as recoupment, the insurance proceeds for the damage to the capital works are not an assessable recoupment under section 20-20 of the ITAA 1997.

Insurance proceeds and depreciating assets

If a balancing adjustment is required for property on which you incurred a loss or outgoing, no part of the termination value of the property is an amount you receive as recoupment of the loss or outgoing (subsection 20-25(5) of the ITAA 1997).

Therefore, the portion of insurance proceeds you receive for the destruction of your depreciating assets is not an assessable recoupment, as the amount you will receive is the termination value of the destroyed depreciating assets.

Repairs

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises used for income producing purposes, to the extent that the expenditure is not capital in nature.

Taxation Ruling TR 97/23 Income tax: deductions for repairs explain the circumstances in which deductions for repairs are allowable. TR 97/23 states that what is a repair for the purposes of section 25-10 of the ITAA 1997 is a question of fact and degree in each case having regard to the appearance, form, state and condition of the particular property at the time the expenditure is incurred and to the nature and extent of the work done to the property. The ruling further states that repairs mean the remedying or making good of defects in, damage to, or deterioration of, property. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated.

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. 

TR 97/23 states that with a repair, the work restores the efficiency of function of the property without changing its character. An improvement, on the other hand, provides a greater efficiency of function in the property. It involves bringing a thing or structure into a more valuable or desirable state or condition than a mere repair would do.

In your case, the work done to replace the damaged roof, gutters, insulation batts, ceiling, cornices, security screens, windows, doors, cleaning and painting are considered to be deductible repairs. The work is not regarded as an improvement or capital in nature. Therefore the associated expenses are deductible repairs under section 25-10 of the ITAA 1997.

The replacement of depreciating assets is capital in nature and no deduction under section 25-10 of the ITAA 1997 is allowed. Please see below for further details.

Kitchen, bathroom vanity and mirror and rewiring

The kitchen is a separately identifiable capital item with its own function. As a consequence, it is an entirety in itself and its replacement is a renewal of the entirety. The expenditure is capital in nature and not a deductible repair (Lindsay v Federal Commissioner of Taxation (1960) 106 CLR 377; 12 ATD 197; (1960) 8 AITR 99).

Furthermore the replacement of the kitchen is considered to be a substantial improvement and therefore capital in nature.

The cost of bathroom fittings such as the bathroom vanity and mirror are permanent fixtures to the property and are capital in nature. Such items are fixed with the intention that they shall remain there indefinitely.

Similarly, the electrical rewiring work is fixed to the property and is considered to be part of the building and capital in nature.

Therefore the expenses in relation to the new kitchen, bathroom vanity and mirror and rewiring and associated plumbing and lighting and not deductible as repairs under section 25-10 of the ITAA 1997. However a capital works deduction is allowed under Division 43 of the ITAA 1997.

Deduction for new capital works

Division 43 of the ITAA 1997 provides a deduction for capital works. Capital works includes buildings and structural improvements, and also extensions, alterations or improvements to buildings and structural improvements where a residential property is used for income producing purposes.

Subsection 43-25(1) of the ITAA 1997 provides that the rate of deduction for capital works which began after 26 February 1992 for a residential rental property is 2.5%. However, a deduction cannot be made prior to the completion of the capital works (section 43-30 of the ITAA 1997).

The kitchen, bathroom vanity and mirror and wiring are permanently fixed in place and are considered to become part of the building and therefore capital works for Division 43 of the ITAA 1997 purposes. As construction expenditure will be incurred for these capital works and you will use those capital works to produce assessable income, you will be 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. A 2.5% capital works deduction is allowable.

No deduction for destroyed capital works

Section 43-40 of the ITAA 1997 allows a capital works deduction in given circumstances if the capital work that has been undertaken is destroyed. However, you are only allowed a deduction for un-recouped capital expenditure on a capital item included in a building that has been destroyed in an income year under section 43-40(1) of the ITAA 1997 provided that:

• you have been allowed or are entitled to a deduction for capital works expenditure for your property;

• there is an amount of undeducted construction expenditure for your property; and

• you were using the property to produce assessable income immediately before the destruction or, if not neither you nor any other entity used your property for any other purpose since it was last used by you to produce assessable income.

As your property was built prior to 1985 and you had no undeducted construction expenditure at the date of the fire, you are not entitled to a deduction for the damaged capital works.

Depreciating assets

Section 40-25 of the ITAA 1997 allows a deduction for the decline in value (depreciation) of a depreciating asset you hold, to the extent the asset is used for a taxable purpose.

The air-conditioner, exhaust fan, blinds, carpet and linoleum are regarded as depreciating assets for Division 40 of the ITAA 1997 purposes.

When a depreciating asset is destroyed, a balancing adjustment event occurs (section 40-295 of the ITAA 1997). You need to calculate a balancing adjustment amount to include in your assessable income if you receive insurance proceeds for a depreciating asset that has been fully depreciated. However, you may choose to offset the assessable balancing adjustment amount arising from the destruction of the asset against the cost of one or more replacement assets.

Example - Shearing shed destroyed by fire

Your shearing shed (which has been fully depreciated) is destroyed by fire. You receive insurance proceeds of $40,000 for the destroyed shed.

As the shed has been fully depreciated this means that you would have an assessable balancing adjustment amount of ($40,000 - $0) $40,000.

However, if you buy/build a replacement shed for $40,000 you can choose to offset the assessable balancing adjustment amount ($40,000) against the cost of the replacement shed ($40,000). This means that you will not need to include any of the insurance proceeds received for the destroyed shed in your income tax return; however, it should be noted that the opening balance of the replacement shed for depreciation purposes will also be reduced by $40,000 to $0 and you will not be entitled to claim depreciation on the shed.

By making the choice to not include a balancing adjustment amount in your assessable income (and reducing the cost of the replacement shed for depreciation purposes) the taxation consequences of receiving the insurance proceeds for the destroyed shed are income tax neutral so that you are put in the same position for tax purposes as before the fire.

In your case, a balancing adjustment may be required for the depreciating assets that were destroyed in the fire. These include the internal blinds, floor coverings, exhaust fan and air-conditioners.

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 (subparagraph 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 (subparagraph 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 (subparagraph 40-285(2)(b) of the ITAA 1997).

As the insurance proceeds, you received for the destruction of each of your depreciating assets (termination value) is more than the adjustable value of each of these depreciating assets, 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, 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 the balancing adjustment amounts in assessable income.

Therefore the balancing adjustment amounts will be included in assessable income unless you choose to treat the balancing adjustment amounts as a reduction in the opening adjustable value of the replacement assets.

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.