Edited version of your written advice

Authorisation Number: 1051235678731

Date of advice: 13 June 2016

Ruling

Subject: Rental property expenses – repair or improvement

Question 1

Is the cost of replacing a retaining wall located on your rental property an allowable deduction as a repair?

Answer

No.

Question 2

Is the cost of replacing the retaining wall capital expenditure, which is eligible for an annual write-off deduction under the capital works provisions?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2016

Year ending 30 June 2017

The scheme commenced on

1 July 2015

Relevant facts

You purchased the rental property in 201X income year.

The rental property is about XX years old.

You repaired a retaining wall at the rental property prior to replacing it.

The repair did not last long due to termite damage and the age of the wall.

In the 201Y income year you had to replace the left side of the wall and decided to also replace the right side and front of the wall.

It was more economical to replace the whole wall rather than part of it.

You replaced it using the same material as the old wall timber.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 25-10

Income Tax Assessment Act 1997 Section 43-15

Income Tax Assessment Act 1997 Section 43-20

Income Tax Assessment Act 1997 Section 43-25

Income Tax Assessment Act 1997 Section 43-140

Income Tax Assessment Act 1997 Section 43-30

Income Tax Assessment Act 1997 Section 43-70

Reasons for decision

Repairs

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) generally allows a deduction for expenditure incurred on repairs to premises or plant held or used by a taxpayer for the purpose of producing assessable income. However, capital expenditure is not deductible under section 25-10.

Taxation Ruling TR 97/23 (TR 97/23) explains the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10 of the ITAA 1997.

TR 97/23 states that in its context in section 25-10 of the ITAA 1997, 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 and contemplates the continued existence of the property. Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing it's character and may include restoration to its former appearance, form, state or condition. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated.

Expenditure incurred for repairs is not deductible under section 25-10 of the ITAA 1997 if the expenditure is of a capital nature. TR 97/23 states that expenditure for repairs to property is capital expenditure if the expenditure, rather than being for work done to restore the property by renewal or replacement of subsidiary parts of a whole, is for work that is a renewal in the sense of a reconstruction of the entirety.

The term 'entirety' is used by the courts in repair cases to refer to something 'separately identifiable as a principal item of capital equipment' (Lindsay v FC of T (1960) 106 CLR 377 at 385; (1960) 12 ATD 197 at 201). In Lindsay's case, the taxpayer company was a slip proprietor and ship repairer. It claimed a deduction for the cost of reconstructing one of two slipways. In finding that the work was not repairs, Kitto J rejected the taxpayer's submission that either the whole slip (comprising the slipway, hauling machines, cradles and winches by which vessels were manoeuvred on to it) or the whole of the business premises containing the slipway should be regarded as the relevant entirety. His Honour decided that the slipway was an entirety by itself and not a subsidiary part of a larger whole.

Property is more likely to be an entirety, as distinct from a subsidiary part, if (TR 97/23):

● the property is separately identifiable as a principal item of capital equipment; or

● the thing or structure is an integral part, but only a part, of entire premises and is capable of providing a useful function without regard to any other part of the premises; or

● the thing or structure is a separate and distinct item of plant in itself from the thing or structure which it serves; or

● the thing or structure is a 'unit of property' as that expression is used in the depreciation deduction provisions of the income tax law.

TR 97/23 states that a reconstruction of the whole of property (for example, fencing or a railway) is not a deductible repair. The ruling states:

"Replacement or substantial reconstruction of the entirety, as distinct from the subsidiary parts of the whole, is an improvement."

The issue of repairs to retaining walls has been considered in a number of cases, including Case S13, 85 ATC 171 and Mt Isa Mines Ltd v FC of T 90 ATC 4267.

In Case S13, two retaining walls built on a rental property to prevent soil erosion were each held to be an 'entirety'. The replacement following storm damage, with two new retaining walls which were higher, stronger and of different material, was held to be an improvement to a fixed capital asset and not repairs.

In Mt Isa Mines Ltd v Federal Commissioner of Taxation, a mining company constructed a retaining wall to create a tailings dam on a mine site. The retaining wall was intended to be the first stage of a much larger development. Following seepage through the retaining wall a new retaining wall, or embankment, was constructed with the result that the old retaining wall was submerged. The Federal Court held that the expenditure incurred in building the new retaining wall was not deductible because it was an outgoing of capital or of a capital nature and did not constitute repairs to the old retaining wall or to the dam.

In your case, your expenditure on replacing the retaining wall is not a deductible repair under section 25-10 of the ITAA 1997 because the whole retaining wall was replaced, making it a reconstruction of the entirety. The cost of replacing an entire retaining wall with a new retaining wall is of a capital nature.

Deduction for Capital Works

Your expenditure on replacement of the retaining wall is not deductible outright in the income year in which it is incurred, because it is capital expenditure. However, a deduction may be available under the capital works provisions.

The capital works provisions allow a deduction for certain capital expenditure on the construction of buildings and other capital works which are used for the purpose of producing assessable income. Eligible construction expenditure is written off over a number of years.

Division 43 of the ITAA 1997 applies to capital works being certain buildings, and also capital works that are structural improvements begun after 26 February 1992. Examples of structural improvements include fences and retaining walls. Your expenditure on the new retaining wall is therefore subject to the capital works provisions.

The amount you can deduct is a portion of your construction expenditure. In the case of structural improvements begun after 26 February 1992 the rate of deduction is 2.5%. However, not more than 100% of your construction expenditure can be deducted. This imposes a time limit on the period over which your construction expenditure can be deducted. In your case, the construction expenditure in relation to the new retaining wall may be written off over a 40 year period, at a rate of 2.5% per year.

However, it should be noted that the write-off deduction is allowable only for the period your property is rented or is available for rent. It should also be noted that you cannot deduct an amount for any period before the completion of construction of the capital works (the retaining wall).

Section 43-70 of the ITAA 1997 defines construction expenditure as capital expenditure incurred in respect of the construction of capital works. Taxation Ruling TR 97/25 states that construction expenditure includes preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits.

However, section 43-70 of the ITAA 1997 states that construction expenditure does not include:

● expenditure on acquiring land; or

● expenditure on demolishing existing structures; or

● expenditure on clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation works; or

● expenditure on landscaping.