Edited version of private advice

Authorisation Number: 1051999138583

Date of advice: 29 June 2022

Ruling

Subject: Rental property expenses

Question

Will the costs associated with the application of Teretek Resin be deductible as a repair as per section 25-10 of the Income Tax assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You purchased property in 20XX as an investment property.

You obtained a building inspection as a pre-purchase inspection.

You were provided videos, photos, and a verbal outcome of the pre-purchase inspection however you were not provided a written pre-purchase building report.

You were first advised of movement cracks within the property by your real estate agent via an email a few weeks after purchase.

One of the owners stayed at the property a few nights before purchase and did not see any movement cracks.

This owner also specifically asked if the location of the property, on a hill, would present any stability issues and was verbally advised the property was stable.

You advise the property was freshly painted at the time of purchase therefore any cracks were not visibly noticeable at time of purchase.

These movement cracks were not rectified right away, and your real estate agent watched them over time to see if they stabilised or got worse.

Some months after purchase you were advised by your real estate agent the cracks were getting worse.

You obtained a quote for a foundation treatment and correction using Teretek Resin in 20XX.

You did not proceed with the works.

A further twelve months passed and the cracks in the property have become severe.

You requested a requote of the works to be completed.

You were provided a revised quote.

You contacted your insurance company to determine if you were covered.

Your insurance claim was denied.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 section 110-25

Reasons for decision

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to premises used for income producing purposes. However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs where the expenditure is of a capital nature.

Taxation Ruling TR 97/23 Income tax: deductions for repairs (TR 97/23) explains the principles and the circumstances in which expenditure incurred for repairs is an allowable deduction. Although the word repair is not defined within the taxation legislation, paragraph 13 of TR 97/23 states that a repair means the remedying or making good of defects in, damage to, or deterioration of property.

Paragraph 15 of TR 97/23 goes further to explain that a repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing its 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.

TR 97/23 also states that expenditure to remedy defects, damage or deterioration in existence at the date of acquisition is constituted as initial repairs.

59. Expenditure incurred on an initial repair after property is acquired, if the expenditure is incurred in remedying defects, damage or deterioration in existence at the date of acquisition, is capital expenditure and is not, therefore, deductible under section 25-10. This is so whether the property is purchased or obtained under lease or licence by the taxpayer. The cost of effecting an initial repair is still not deductible even if some income happens to be earned after acquisition but before the repair expenditure is incurred: but see paragraphs 63 to 66 of this Ruling in relation to dissecting or apportioning initial repair costs.

60. The main consideration in relation to initial repairs is the appearance, form, state and condition of the property and its functional efficiency when it is acquired. Expenditure that remedies some defect or damage to, or deterioration of, property is capital expenditure if the defect, damage or deterioration:

(a) existed at the time of acquisition of the property; and

(b) did not arise from the operations of the person who incurs the expenditure.

Paragraph 61 of TR 97/23 specifically considers the fact of whether a taxpayer was not aware of the need for repairs at the time of purchase.

61. It is immaterial whether at the time of acquisition the taxpayer was aware of the condition of the property, including its need for repair. It is also immaterial whether the purchase price (or lease rentals) reflected the need for repairs. We consider that the English Court of Appeal decision in Odeon Associated Theatres Ltd v. Jones (Inspector of Taxes) [1972] 1 All ER 681 is not authority in Australia for a contrary view. An initial repair expense is not the type of repair expenditure ordinarily incurred as a working or operating expense in producing assessable income or in carrying on a business. This is because it lacks a connection with the conduct or operations of the taxpayer that produce the taxpayer's assessable income. It is essentially an additional cost of acquiring the property or an improvement in the quality of the property acquired. Initial repair expenditure relates to the establishment of the profit - yielding structure. It is capital expenditure and is not deductible under section 25-10.

In your case, you acquired the property in 20XX, and you were first notified of the movement issues with the property shortly afterwards. The deterioration of the building which resulted in the repairs would have occurred over a period of time and not just since you purchased the rental property. Thus, the Commissioner considers the damage was present at the time the property was acquired.

The damage did not occur at a time you held or used the property for an income producing purpose and the work being done to rectify the structural damage is an initial repair and the cost involved is capital expenditure. Therefore, these repairs would constitute as an initial repair and are not deductible as initial repairs are capital in nature.

Consequently, you are not entitled to a deduction under section 25-10 of the ITAA 1997 for the building work being done on your rental property.

Capital works deduction

ATO Interpretive Decision ATO ID 2003/795 Income Tax - Capital Works: remedial painting for newly acquired property considers whether an initial repair is deductible as capital works under section 43-70 of the ITAA 1997. As initial repairs are a capital expense that improve a building, they will be deductible if none of the exclusions in section 43-70 apply.

In your case, none of these exclusions apply therefore the expenditure is qualifying construction expenditure for the purposes of Division 43 of the ITAA 1997. A capital works deduction is generally claimed over 40 years, that is 2.5% of the cost is claimed each year.

Cost base

The first element of the cost base of a capital gains tax (CGT) asset is generally the cost of the asset when you bought it. However, it also includes certain other costs associated with acquiring, holding and disposing of the asset. The cost base of a CGT asset is made up of five elements. You need to add together all these elements to work out your cost base for each CGT asset.

In your case, the expenses incurred can be included in the third element of your cost base as per section 110-25(5) of the ITAA 1997. However, section 110-145 of the ITAA 1997 prevents you from including any part of the expense that has already been deducted as a capital works deduction.