Edited version of private advice

Authorisation Number: 1052067998701

Date of advice: 21 December 2022

Ruling

Subject: Deductions - vacant land

Question 1

Can you claim a deduction for expenses incurred while holding land with substantial building against your personal income?

Answer

No.

Question 2

Can you claim expenses under Division 40 or Division 43 for the work carried out on the property until it was converted to vacant land?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You purchased a property (the property).

The size of the property was XXXXm².

There was a shed on the property that covered XXXm².

The property is zoned as village, which is either residential or commercial.

You stated that your intentions were to rent out the property. You verbally engaged a real estate agent to find a tenant, however, the property was never advertised for rent.

Your next intentions for the property were to commence a business to store and sell collectors/antique vehicles, however no business was ever set up.

In XX 20XX you hired a maintenance service to carry out XX days of labour on the property.

In XX 20XX you hired another entity to remove scrap from the property.

In XX 20XX you hired another entity to remove rubbish within the building and trees that were protruding on the building.

In XX 20XX XX XX equipment was used to complete some works at the property.

Between XX and XX 20XX you hired XX XX and XX to remove the building and concrete foundation

You have revised your intentions to develop the land.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-10

Income Tax Assessment Act 1997 Section 26-102

Income Tax Assessment Act 1997 Section 43-40

Reasons for decision

Question 1

Claiming Deductions for expenses incurred whilst holding land with a substantial building

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income. However, you cannot deduct a loss or outgoing to the extent that it is capital, private and domestic in nature, or incurred in gaining exempt income.

Section 26-102 of the ITAA 1997 effects the deductibility of expenses incurred on or after 1 July 2019 that relate to holding vacant land, such that it disallows deductions for expenses associated with holding vacant land that would otherwise be deductible under section 8-1 of the ITAA 1997. However, you may be excluded from the operation of this section if the land is used in carrying on a business.

The meaning of vacant land, for the purposes of section 26-102 of the ITAA 1997, is land that has 'no substantial and permanent structure in use or available for use on the land having a purpose that is independent of, and not incidental to, the purpose of any other structure or proposed structure'.

Relying on the meaning of vacant land outlined above, the three tests used to determine whether section 26-102 of the ITAA 1997 applies are:

Relying on the meaning of vacant land outlined above, the three tests used to determine whether section 26-102 of the ITAA 1997 applies are:

•         Is there a substantial and permanent structure on the land?

•         If there is a structure, is it in use or available for use?

•         If there is a structure available for use, is it independent of and not incidental to the purpose of any other structure, or proposed structure?

Test One: Is there a substantial and permanent structure on the land?

Substantial

The Explanatory Memorandum to the Treasury Laws Amendment (2019 Tax Integrity and Other Measures No. 1) Bill 2019 (the Explanatory Memorandum) at Chapter 3 explains the law relating to limiting deductions for vacant land. The Explanatory Memorandum provides that, to be substantial, a building or other structure needs to be significant in size, value or some other criteria of importance in the context of the relevant property. A structure will not be substantial if it only has value as an adjunct to another structure, such as a residential garage or letterbox (Explanatory Memorandum paragraphs 3.18 - 3.19).

The context of the land, in your circumstances, is that it is zoned village so can be either residential or commercial. Generally, the purpose of residential land is to be used for owner-occupied housing. The shed on the land covers XXX square metres and the land is a XXX square metre block. The size of the shed is a substantial structure in comparison to the size of the land, therefore it is accepted that the shed is significant in size in the context of the land.

In summary, it is accepted that the shed is a substantial structure.

Permanent

To be permanent, a structure needs to be fixed and enduring and not have been built for a temporary purpose (Explanatory Memorandum paragraph 3.20). In your circumstances, the shed is affixed to a concrete foundation and has an industrial sliding door. These features indicate permanency, and it is therefore accepted that the shed is a permanent structure.

Test Two: If there is a structure, is it in use and available for use?

The structure was never in use or available for use.

Test Three: If there is a structure available for use, is it independent of and not incidental to the purpose of any other structure, or proposed structure?

Whether a structure has an independent purpose that is not incidental to the purpose of another structure is a question of fact. This requires consideration of the context of the structure, land on which it is located and any other structures that have been, are in the process of being, or may be expected to be constructed on the land (Explanatory Memorandum paragraph 3.21). Importantly, structures that have the purpose of increasing the utility of another structure are not considered to be independent (Explanatory Memorandum paragraph 3.22).

In the context of land for residential purposes, it is the general rule that even if a garage or shed is considered to be permanent and substantial, the structure does not have a purpose independent of any potential, proposed or existing main residence on the land. The purpose of the garage or shed structure is to increase the utility of the main residence (Explanatory Memorandum paragraph 3.23).

As the land, could be used for commercial purposes according to its zoning, it may be accepted that the structure in this case was substantial and it is independent of and not incidental to the purpose of any other structure, or proposed structure. However, as it was not used and no business activities commenced, cannot be considered that it was but it was in use or available for use.

While the structure may have been considered substantial and permanent it would not have been considered independent for residential purposes, and no business activities commenced for the structure to be used independently either. Therefore, 26-102(2) will operate to deny any deduction as no business actually commenced or existed.

Question 2

Detailed reasoning

Section 25-10 of Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to premisses 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 capital nature.

Capital works

Section 43-40 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a capital works deduction if the capital work that has been undertaken is destroyed. This applies to both voluntary destruction (such as site clearance for redevelopment) and involuntary destruction (such as damage caused by fire or flood) of capital works undertaken.

You are allowed a deduction for unrecouped capital expenditure on a capital item included in a building that has been destroyed in an income year under section 43-40(1) of the ITAA 1997 provided that:

•         you have been allowed or are entitled to a deduction for capital works expenditure for your property;

•         there is an amount of undeducted construction expenditure for your property; and

•         you were using the property to produce assessable income immediately before the destruction or, if not neither you nor any other entity used your property for any other purpose since it was last used by you to produce assessable income.

Distinction between a repair and an improvement

The meaning of 'repair' or 'repairs' is considered in paragraphs 12 to 30 of this Ruling. In the case of a 'repair', broadly speaking, 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 - usually in some existing function. It involves bringing a thing or structure into a more valuable or desirable form, state or condition than a mere repair would do. Some factors that point to work done to property being an improvement include whether the work will extend the property's income producing ability, significantly enhance its saleability or market value or extend the property's expected life.

To distinguish between a 'repair' and an 'improvement' to property, one needs to consider the effect that the work done on the property has on its efficiency of function. This is the determinative test.

If the work entails the replacement or restoration of some defective, damaged or deteriorated part of the property, one does not focus on the effect the work has on the efficiency of function of the part. That is not determinative of whether the property is repaired or improved. It is a relevant factor to take into account, however, in considering the effect of the work on the property's efficiency of function. It is possible, for instance, that the replacement of a subsidiary part of property with a part better in some ways than the original is a repair to the property without the work being an improvement to the property.

Relevant considerations, consistently with the approach taken by the High Court in the W Thomas & Co case and the Western Suburbs Cinemas case, in distinguishing generally between a repair and an improvement, are:

(a) whether or not the thing replaced or renewed was a major and important part of the structure of the property (at 86 CLR 106; 9 ATD 454);

(b) whether the work performed did more than meet the need for restoration of efficiency of function (at 86 CLR 106; 9 ATD 454 and at 115 CLR 72; 14 ATD 87), bearing in mind that 'repair' involves a restoration of a thing to a condition it formerly had without changing its character;

(c) whether the thing was replaced with a new and better one (at 86 CLR 106; 9 ATD 454); and

(d) whether the new thing has considerable advantages over the old one, including the advantage that it reduces the likelihood of repair bills in the future (at 86 CLR 106; 9 ATD 454).

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.

Expenditure on demolishing existing structures is not an amount that can contribute to a deduction for capital works under section 43-10 of the ITAA 1997 as it is not construction expenditure (paragraph 43-70(2)(b) of the ITAA 1997). However, such expenditure may be taken into account in calculating a deduction under section 43-40 of the ITAA 1997.

Paragraph 43-40(1)(c) of the ITAA 1997 has two limbs. The first limb is satisfied if 'your area' was used immediately before the destruction in a way that applies to it under the table in section 43-140 of the ITAA 1997. The required use for a building is that it is used for the purpose of producing assessable income. If it has not been used for this purpose, then the second limb allows a deduction if no entity has used the area for any purpose since it was last used by the taxpayer for the purpose of producing assessable income.

In considering if the requirements of paragraph 43-40(1)(c) of the ITAA 1997 are satisfied the meaning of 'immediately before the destruction' must be considered. Section 43-160 of the ITAA 1997 is also relevant in this consideration, which provides that a part of your area is taken to be used, for use or available for use for a particular purpose at a time if, at that time:

•         it was maintained ready for use for that purpose

•         it was not used or for use for any other purpose, and

•         its use or intended use for that purpose had not been abandoned.

In your circumstances, the structure was not used for the purpose of producing income prior to any works to remove it. It is considered that immediately before the destruction occurred the property had never been used for income producing purposes.

For completeness, we have further considered whether an amount can be deducted under section 43-40 of the ITAA using the method statement contained in section 43-250 of the ITAA 1997. Under this method statement you are required to reduce your deduction where you have received or have a right to receive amounts for the destruction of the capital works.

Section 43-255 of the ITAA 1997 provides that the amounts you have received or have a right to receive for the destruction of the capital works include:

•         an amount received under an insurance policy or otherwise for the destruction of the capital works, and

•         an amount received for disposing of any property salvaged from the demolition, less any demolition expenditure incurred on the property.

Thus, in calculating the balancing deduction under section 43-250 of the ITAA 1997, demolition expenditure acts to offset the lessening of deduction that occurs because of the fact that an amount has been received for disposing of the destroyed capital works.

ATO Interpretive Decision 2003/833 considers an example where a taxpayer has $50,000 undeducted construction expenditure for a building, they incurred $5,000 in demolition costs and did not receive an amount for the destruction of capital works:

Example 3

The taxpayer did not receive any amount for the destruction of the building, and did not receive any amounts for disposing of the destroyed building. The reduction amount calculated as being received under section 43-255 of the ITAA 1997 is zero. The $5,000 excess of demolition expenditure over the amount received for disposing of the destroyed building is not deductible under Division 43 of the ITAA 1997.

The balancing deduction under section 43-250 of the ITAA 1997 is $50,000 ($50,000 - $0).

There may be capital gains tax implications under Part 3-1 of the ITAA 1997 for the balance of the demolition expenditure incurred (in the example, $5,000).

In your case, you are not entitled to a deduction for the demolition expenses you incurred. You received no amounts for the destruction of the capital works the demolition expenses will not act to increase the deduction available to you under section 43-40 of the ITAA 1997.

Therefore, you are not entitled to a deduction for under subsection 43-40(1) of the ITAA 1997, rather any costs incurred in relation to the demolition of shed may form part of the property's cost base

Depreciating assets

A depreciating asset is one that has a limited effective life and can reasonably be expected to decline in value over the time it's used. Land, trading stock and some intangible assets are not depreciating assets.

Depreciation deductions are limited to the extent to which you use an asset to earn income.

In this case, even if the shed was considered a depreciating asset, it was not used to producing income or for a taxable purpose. Therefore, there can be no application of Division 40 of the ITAA.