Edited version of private advice

Authorisation Number: 1052063055532

Date of advice: 1 December 2022

Ruling

Subject: Rental expenses - repairs or improvements

Question 1

Are the expenses relating to the replacement of beam, window flashing as repairs under 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) or as maintenance under 8-1 of the ITAA 1997?

Answer

Yes.

Question 2

Are the expenses relating to the replacement of the roof deductible as capital works under Division 43 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Financial Year ended 30 June 20XX

Financial Year ending 30 June 20XX

The scheme commences on:

1 July 2020

Relevant facts and circumstances

You own an investment property (the property).

The property has been rented out since you purchased it.

During recent years, it became apparent to you that there was rain entering the property through a large bay window in the lounge/dining area. The water seepage caused significant damage to the bay window.

You subsequently engaged a builder to replace the bay window at the property. You were of the understanding that the water seepage would cease once the bay window was replaced. You made no change to the structure or design of the bay window except for the removal or addition of one rail.

During the repairs to the bay window, it was identified that a laminated beam under the floor joists was severely rotted and needed to be replaced.

Towards the end of the repairs to the bay window, an episode of rain occurred revealing that there was still an issue with water ingress. You sought an assessment of the cause of the water ingress and were advised that there was insufficient overlap of the roofing iron into the gutter, and this was allowing water to be blown into the roof cavity. You were further advised to remove the roof gutter, lift the roof sheets and slide new sheets underneath to create an overlap. It was also noted that there had been some earlier repairs to the roof with silicone which could be contributing to the water ingress. You decided to replace the roof as it was only slightly more expensive then repairing the roof.

Following the replacement of the roof, it was identified that there was still an issue with water ingress into the roof cavity at the property. You sought an opinion from the company who had replaced the roof, and you were advised that there was an issue with the flashing under the roof gutter. You were advised to remove the gutter and instal custom flashing, which you attended to.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 Division 43

Reasons for decision

General deductions

Under section 8-1 of the Tax Assessment Act 1997 (ITAA 1997) you can claim a deduction for losses and outgoings which are incurred in the course of gaining or producing assessable income, unless the losses or outgoings are of a capital, private or domestic nature.

Deductions for repairs

Under section 25-10 of the ITAA 1997 you can deduct 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 tax legislation and takes its ordinary meaning. Repair involves a restoration of a thing to a condition it formerly had without changing its character (W Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58; (1965) 14 ATD 78; (1965) 9 AITR 710).

Expenditure for repairs is of a capital nature where:

•         the work is an initial repair

•         the extent of the work carried out represents a renewal or construction of the entirety, or

•         the work results in a greater efficiency of function, therefore representing an improvement rather than a repair.

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. The term 'repair' 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 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 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.

It is acknowledged in TR 97/23 that 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. However, if the work amounts to a substantial improvement, addition or alteration, it is not a repair and is not deductible under section 25-10 of the ITAA 1997.

It is accepted that all the works in question were undertaken to fix damage caused by water ingress, were not initial repairs. However, we must also consider whether any of the works constituted a replacement of an entirety or improvements.

In Lindsay v. Federal Commissioner of Taxation (1961) 106 CLR 377; [1961] HCA 93 (Lindsay's Case), the High Court (Kitto J) held that expenditure incurred to renew a slipway was a renewal of an entirety and was not deductible as a repair under section 53 of the Income Tax Assessment Act 1936 (which was re-written as section 25-10 of the ITAA 1997). This conclusion was drawn on the basis that his honour considered the slipway to be a separately identifiable capital item, maintaining its own function. Substantially the whole of the old slipway had been demolished and replaced by a new slipway, comprising all new components and was a renewal of a separately identifiable item and not a repair.

The Commissioner considered the issue of replacement of an entirety in the rental property context in ATO Interpretative Decision 2003/222. In that ATO ID, damaged kitchen cupboards in a rental property were replaced. The Commissioner considered that the cupboards were a separately identifiable thing representing an entirety in themselves. Consequently, their replacement constituted a replacement of an entirety and was capital in nature. Therefore, the expenditure was not deductible as a repair under section 25-10 of the ITAA 1997. However, the Commissioner considers that kitchen cupboards are capital works which are eligible for the 2.5% capital works deduction. As a capital works deduction is available, a depreciation deduction is not allowable (subsection 40-45(2) of the ITAA 1997).

Based on the facts, the work done to remediate damage caused by water ingress constitute repairs or maintenance, as the work did not change the character of the property and did not improve the efficiency of function of the property. Accordingly, amounts incurred to replace the bay window, replace the laminated beam and instal the flashing would be deductible under section 25-10 of the ITAA 1997.

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. Replacing a roof when only part of it is damaged or renovating a bathroom is classified as an improvement and not immediately deductible. 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%.

In your case, the replacement of the roof is considered capital works. You are entitled to a 2.5% capital works deduction under Division 43 of the ITAA 1997.