Edited version of private advice

Authorisation Number: 1052000495454

Date of advice: 11 July 2022

Ruling

Subject: Rental deductions - capital works

Question

Are the expenses you incurred on your property for replacement of 2 retaining walls considered a deductible repair under section 25-10 of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

Period ended 30 June 20XX

The scheme commences on:

June 20XX

Relevant facts and circumstances

You purchased a rental property (the Property) in approximately July 19XX.

The Property is in your name.

The Property has been continuously rented from 19XX until 20XX.

When the property was purchased it was new.

You subsequently moved back into the property and identified structural problems with two retaining walls that underpin the rest of the house foundations.

The house is on a very steep block. For structural integrity the house is built on its footings together with one retaining wall holding in place the footings of the house and a second retaining wall underpinning the first retaining wall and the house foundations.

You arranged for a contractor to investigate the problem and they reccommended that both retaining walls be replaced in full. No written report was provided.

The two retaining walls will be completed by 30 June 20XX and the expense paid for by 30 June 20XX.

There is no insurance claim.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 25-10

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.

The word 'repair' is not defined within the taxation legislation. Accordingly, it takes its ordinary meaning. In W Thomas & Co v. FC of T (1965) 115 CLR 58, it was held that a 'repair' involves a restoration of a thing to a condition it formerly had without changing its character. It is the restoration of efficiency in function rather than the exact repetition of form or material that is significant.

Taxation Ruling TR 97/23 Income tax: deductions for repairs deals with the issue of deductions for repairs.

TR 97/23 provides 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 (paragraphs 36-42), or the works result in a greater efficiency of function in the property, therefore representing an 'improvement' rather than a 'repair' (paragraphs 44-58).

Taxation Ruling TR 97/23 states:

•         Works can fairly be described as 'repairs' if they are done to make good damage or deterioration that has occurred by ordinary wear and tear, by accidental or deliberate damage or by the operation of natural causes (whether expected or unexpected) during the passage of time.

•         To repair property improves to some extent the condition it was in immediately before repair. A minor and incidental degree of improvement, addition or alteration may be done to property and still be a repair. If the work amounts to a substantial improvement, addition or alteration, it is not a repair and is not deductible under section 25-10.'

An 'entirety' is defined as something 'separately identifiable as a principal item of capital equipment' (Lindsay v. Federal Commissioner of Taxation (1960) 106 CLR 377 at 385).

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.

Division 43 of ITAA 1997 provides for a system of deducting capital expenditure incurred in the construction of buildings and other capital works used to produce assessable income.

Section 43-30 of the ITAA 1997 provides that you cannot deduct any amount for a period before the construction is complete.

Section 43-140 of the ITAA 1997 sets out the way you must use your area in an income year for a deduction to be allowed under section 43-10 (the main deduction provision). The relevant use depends on the time when the capital works began (Column 1) and the type of capital works (Column 2). Column 3 sets out the use. The table below only includes details pertaining to construction after 30 June 1997, which is relevant to your circumstances.

* Note: The area you own, lease or hold is called your area.

Where the criteria of Table 43-140 have been met, Section 43-210 of ITAA 1997 provides the formula to calculate the deduction, as per below:

Portion of your CE × Days used × 0.025

365

where:

portion of your CE is the portion of * your construction expenditure that is attributable to the part of * your area that you did not use in the * 4% manner but was used as described in Table 43-140 (Current year use).

days used is the number of days in the income year that:

(a) you owned or were the lessee of that part of * your area and used it in that manner; or

(b) you were the holder of that part of * your area under a • quasi-ownership right over land granted by an * exempt Australian government agency or an * exempt foreign government agency and used that part of your area in that manner."

Application to your circumstances

The original retaining walls were investigated by a contractor, who made a recommendation for both walls to be replaced in full. Therefore, the replacement of the walls goes beyond restoring the property to its original state. In this case, the whole of the retaining walls are to be replaced. These changes represented both a renewal or reconstruction of an entirety, and an improvement to a fixed capital asset.

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. 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.

In your case, the "construction expenditure area" does not exist until the capital works commence. Furthermore, as per section 43-30 you cannot claim a deduction for any period before the construction is complete.

Assuming that the works have been completed and paid for prior to 30 June 20XX, because you were not using the area to produce assessable income at that time (as per table 43-140), there is no amount that is deductible.

If you rent the property out in future, you will be able to claim a capital works deduction at that time. You will also be able to add the cost of the capital works to the fourth element of your cost base when you sell the property (not including any amounts you have been able to deduct).