Edited version of private advice

Authorisation Number: 1051866586528

Date of advice: 19 July 2021

Ruling

Subject: Depreciation deductions for assets in residential premises

Question

Can you claim a depreciation deduction on plant and equipment in residential investment properties that passed to you as the surviving joint tenant owner of the properties?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You and your spouse owned investment rental properties.

You and your spouse owned these properties as joint tenants.

Each property has been an investment rental property at all times.

Your spouse passed away.

The properties, including depreciating assets, passed to you as surviving spouse.

You and your spouse did not have a partnership agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 40-25

Income Tax Assessment Act 1997 Section 40-27

Income Tax Assessment Act 1997 Section 40-35

Income Tax Assessment Act 1997 Section 40-40

Income Tax Assessment Act 1997 Section 40-180

Treasury Laws Amendment (Housing Tax Integrity) Act 2017 (No.126, 2017)

Reasons for decision

Division 40 of the ITAA 1997 contains provisions which allow the claiming of a deduction for the decline in value (depreciation) of depreciating assets, which are used in the production of assessable income.

Section 40-25 of the ITAA 1997 provides that an entity can deduct an amount equal to the decline in value for an income year of a depreciating asset that the entity held, to the extent that it is used for a taxable purpose.

This rule was limited with the inclusion of section 40-27 of the ITAA 1997.

From 1 July 2017 resulting from the Treasury Laws Amendment (Housing Tax Integrity) Act 2017 (No.126, 2017) new rules under section 40-27 of the ITAA 1997 apply for deductions for decline in value in certain second-hand depreciating assets in relation to residential rental property.

For the purposes of section 40-27, the requirement is that the holder held the asset when it was first used or first installed ready for use (i.e. not second hand).

The changes mean that a taxpayer cannot claim a deduction for a decline in value of certain second hand depreciating assets against residential rental property, unless they are using the property in carrying on a business (including the business of letting out rental properties) or they are an excluded entity.

The amendments do not affect deductions that arise:

•         In the course of carrying on a business; or

•         For corporate tax entities, superannuation plans other than self-managed superannuation funds, public unit trusts, managed investment trusts and unit trusts or partnerships, all the members of which are entities of a type listed here.

Section 40-27 applies to all other entities including individuals.

Notes to section 40-27 provides further clarity:

13 Application of amendments

13(1) The amendments apply to an entity, for income years commencing on or after 1 July 2017, for assets:

a)    acquired by the entity under contracts entered into; or

b)    otherwise acquired by the entity;

at or after 7.30 pm, by legal time in the Australian Capital Territory, on 9 May 2017.

The Explanatory Memorandum (EM) to the Treasury Laws Amendment (Housing Tax Integrity) Act 2017 provides that the objective of the law was in denying deductions for depreciating assets used in residential premises. The aim was to reduce the amount that could be deducted by an entity for the decline in value of depreciating asset for an income year, to the extent that the asset:

•         Is used or installed for the purposes of gaining or producing assessable income from the use of residential premises for the purposes of providing residential accommodation and

•         Was 'previously used'.

An entity is deemed to have 'previously used' an asset if:

•         The entity is not the first entity that used the asset or installed the asset ready for use (within the meaning of Division 40) other than trading stock

•         The asset is used or installed ready for use during any income year in premises that are, at that time, a residence of the entity or

•         The asset is used or installed ready for use during any income year for a purpose that is not a taxable purpose, other than incidental or occasional use.

The aim of the change was to ensure that '... the reduction is targeted to situations in which there is a particular risk of the overvaluation of previously used depreciating assets.' (paragraph 2.42 of the EM).

Section 40-35 of the ITAA 1997 applies to a depreciating asset (referred to as the underlying asset) that is 'held' by the taxpayer as well as by one or more other entity. It states:

This Division and the provisions referred to in subsection (3) apply to a depreciating asset (the underlying asset ) that you hold, and that is also held by one or more other entities, as if your interest in the underlying asset were itself the underlying asset.

Section 40-35 and the example given in that section, provides that a jointly held interest is treated as two separate interests for Division 40 purposes.

A deceased individual may have held depreciating assets for which she or he was entitled to deduct the capital cost over the effective life of the asset, for each year that the asset was held for use for the purpose of producing assessable income from business or other activities.

Typically, on death the individual stops holding the asset and a balancing adjustment will apply. A balancing adjustment adjusts depreciation deductions to match the real decline in value of the depreciating asset as at the date of death. This is achieved by comparing the termination value of the depreciating asset with its written down (adjustable) value (section 40-285 of the ITAA 1997).

A different balancing adjustment rule applies to depreciating assets on the death of the holder of the assets, depending on whether the asset passes to the personal representative or alternatively, passes directly to a beneficiary or joint tenant.

Application to your case

You and your spouse owned residential rental properties as joint tenants. Each property has been an investment rental property at all times of holding. On the passing of your spouse, the properties passed directly to you as surviving spouse.

Each depreciating asset is considered as 2 separate assets, you retain your interest in the depreciating asset. Your spouse's interest then starts to be held by you from the date of death. For the purposes of CGT, section 40-180(1) item 13 applies regarding any balancing adjustments.

You have acquired your spouse's 'asset'. As a result, it is a second hand asset. The principle that if someone had depreciated a separate asset then the 2^nd owner cannot claim a deduction applies in this instance (section 40-27 of the ITAA 1997).

Accordingly, you cannot claim a depreciation deduction on plant and equipment in residential investment properties that passed to you as the surviving joint tenant owner of the properties under Division 40.