Edited version of private advice

Authorisation Number: 1052113094927

Date of advice: 7 June 2023

Ruling

Subject: CGT - repaid income

Question 1

Is the component of the settlement payment paid to the former tenants of your rental property, which is a repayment of rent and bond that was previously received from the tenants and declared as rental income, non-assessable non-exempt income in accordance with section 59-30 of the Income Tax Assessment Act 1997 (ITAA 1997) in the years the rental income was received?

Answer

Yes.

Question 2

Does the component of the settlement payment paid to the former tenants of your rental property which is a repayment of initial legal fees and insurance expenses previously received from the tenants represent capital expenses that can be added to the Capital Gains Tax (CGT) cost base of the rental property?

Answer

Yes.

Question 3

Are the legal expenses you incurred to undertake legal proceedings in a dispute between you and the former tenants of your rental property allowable as a deduction under section 8-1 of the ITAA 1997?

Answer

No.

Question 4

Do the legal expenses you incurred to undertake legal proceedings in a dispute between you and the former tenants of your rental property represent capital expenses that can be added to the CGT cost base of the rental property?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

The scheme commenced on:

1 July 20xx

Relevant facts and circumstances

Sometime prior to the year 2015 you entered into an agreement with prospective tenants whereby it was proposed that you purchase a property, with the tenants to lease the property from you with an option to purchase the property on certain terms with an equitable interest to be acquired over time.

You borrowed funds from a financial institution to complete the purchase of the property including payment of Stamp Duty and legal fees.

The agreement states that you shall purchase the property outright.

The agreement also states that the tenants shall rent the property from you for a weekly amount equal to the total cost of the principal and interest loan repayment, all rates, insurances, maintenance, and outgoings together with any capital repairs and improvements and 4 weeks bond.

The agreement also states that at any time prior to a particular date around 5 years after the purchase of the property the tenants have the right to acquire the property, at a price determined by calculating all remaining debt from the original purchase borrowings together with all costs, stamp duty and other expenses associated with such proposed sale and the original purchase, and as a result of such a sale the tenants shall be entitled to any net equity in the property.

The agreement also states that should the tenants not acquire the property from you on or before a particular date around 5 years after the purchase of the property, or should there be any default in the payment of rent, you shall be entitled to sell the property at market value provided that such a sale shall be a genuine sale on the open market, and after the payment of any debts associated with the original purchase and all original borrowings, the tenants shall be entitled to any amount paid as rent that has reduced the original borrowings, however any net equity thereafter shall be your property.

The agreement also states that all parties agree that it is intended that this agreement shall create a legal interest in the land for the tenants which could be protected by a caveat if required.

The tenants paid you an amount to reimburse you for initial legal fees and insurance expenses you incurred to acquire the property.

You received rent from the tenants (along with a bond payment) and declared this as rental income for the duration the tenants inhabited the property. Only the minimum repayments were made to the loan which were the rent payments received.

You sold the property to a third party after it became apparent that the tenants were unable to purchase the property. They were evicted from the property shortly prior to the sale.

The tenants (hereafter referred to as the Plaintiffs) subsequently commenced legal proceedings via arbitration in relation to the rent/buy agreement.

The Arbitrator found in the Plaintiffs' favour and ordered you to repay the following amounts to the Plaintiffs:

• An amount representing rent that was to be repaid according to the terms of the agreement.
• An amount representing payment of the bond (less an amount being cost of repairs made to the property after the Plaintiffs moved out of the property).
• An amount for initial legal fees and insurance expenses in relation to the property purchase.
• An amount for part payment of deposit on the property.
• All of the Plaintiffs' costs as agreed or assessed.

You incurred an amount in related legal expenses in the financial year in which the arbitration occurred.

The initial legal fees and insurance expenses incurred to purchase the property were not added to the CGT cost base when calculating the capital gain declared year following the sale of the property.

The legal proceedings also involved the following claims where no amount was awarded to either party:

• A stamp duty payment claim made by the Plaintiffs against you.
• A cross claim lodged by you for rental arrears.
• A cross claim lodged by you for property costs.

In addition, a cross claim made by you relating to a price reduction to the sale price of the property due to the condition of the property after it was rented to the Plaintiffs resulted in a reduction in the amount of bond that was awarded to be repaid to the Plaintiffs.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 59-30

Income Tax Assessment Act 1997 section 110-25

Reasons for decision

Question 1

Section 59-30 of the ITAA 1997 operates to exclude an amount from your assessable income for an income year if you have repaid it in a later income year and you cannot deduct the repayment in any income year. Subsection 59-30(2) explains that this is the case whether or not the amount repaid was part of a larger amount, and clarifies that the amount is non-assessable, non-exempt income whether the obligation to repay the amount existed when you received it or came into existence later.

Application to your circumstances

You received rent from the Plaintiffs (along with a Bond payment) and declared this as rental income over multiple income years where you sold the property to a third party during that financial year.

The sale occurred after it became apparent that the Plaintiffs were unable to purchase the property (as part of a previous agreement made when you initially purchased the property "the agreement"), and they were evicted from the property shortly prior to the sale.

Following the sale, the Plaintiffs initiated legal proceedings against you via arbitration. The arbitration was found primarily in favour of the Plaintiffs, and various amounts were awarded to be paid back to the Plaintiffs. You were ordered to pay the Plaintiffs an amount representing rent that was to be repaid under the terms of the agreement, along with a repayment of bond.

The abovementioned amount representing the rent and bond repaid to the Plaintiffs cannot be claimed as a deduction for any income year, as the rental property was sold in a subsequent income year to those in which rent was received, prior to repaying this amount. Therefore, there is no longer any assessable income against which to claim this amount of repaid rent a deduction.

As such, the amounts of prior year rental income you are required to repay for the preceding financial years are:

• amounts you must repay
• being repaid in a later year, and
• amounts for which you cannot claim a deduction

Therefore, the amounts of prior year income you are required to repay will be classified as non-assessable non-exempt income pursuant to section 59-30 of the ITAA 1997 and will be excluded from your assessable income in the year in which the amounts were received.

Note - section 59-30 of the ITAA 1997 is listed in subsection 170(10AA) of the Income Tax Assessment Act 1936 as one of the provisions not restricted by amendment periods.

Question 2

Upon the sale of an asset to which CGT applies, the asset's cost base, comprising five elements, must be calculated in order to determine the capital gain. Subsection 110-25 of the ITAA 1997 provides that the second element of a CGT cost base includes capital expenditure for incidental costs you incurred to acquire a CGT asset, or that relate to a CGT event.

Subsection 110-35(2) of the ITAA 1997 confirms that the term 'incidental costs' includes remuneration for the services of a legal adviser.

In addition, subsection 110-25(4) of the ITAA 1997 states that the third element of the cost base of a CGT asset is the costs of owning the CGT asset for assets acquired after 20 August 1991, inclusive of insurance expenses.

Application to your circumstances

Under the legal proceedings initiated by the Plaintiffs you were required to repay an amount representing initial legal fees and insurance expenses which were previously received from the Plaintiffs.

You have advised that these expenses were not added to the CGT cost base when calculating the property's capital gain.

As such, these amounts (being of a capital nature) paid back to the Plaintiffs relating to both legal and insurance expenses incurred can be added to the CGT cost base or the property as components of the second and third elements of the cost base respectively.

Question 3

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to earning exempt income.

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses must be considered, as explained in Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634. The nature or character of the legal expense follows the advantage that is sought to be gained by incurring the expenses.

Some legal expenses incurred in producing rental income are deductible. These include the costs of:

• evicting a non-paying tenant;
• taking court action for loss of rental income;
• defending damages claims for injuries suffered by a third party on your rental property.

Legal expenses of a capital nature, however, are not deductible under section 8-1, nor are legal expenses which are properly characterised as private expenses.

Application to your circumstances

In your case, the legal expenses were incurred as a result of legal proceedings regarding a dispute between you and the Plaintiffs over a previous rent / buy agreement.

Overall, the legal proceedings went in favour of the Plaintiffs and the following amounts were awarded to be paid to them:

• An amount representing previously paid rent
• An amount representing payment of bond
• An amount for initial legal fees and insurance expenses
• Am amount for part payment of deposit on the property

In addition, the legal proceedings also involved other claims where no amount was awarded to either party, as follows:

• A stamp duty payment claim made by the plaintiffs against you
• A cross claim lodged by you for 'rental arrears'
• A cross claim lodged by you for 'property costs'

From the above, it is evident that the legal proceedings between you and the Plaintiffs related to a number of different heads of claim, some of which were of a capital nature and some of which were of a revenue nature. Further, some of the claims were decided on by the Arbitrator and others were not.

Consequently, it is considered that no part of the legal expenses incurred could be identified as specifically being related to producing rental income.

Therefore, the expenses are not deductible under section 8-1 of the ITAA 1997.

Question 4

Legal expenses may be included in the second element of the CGT cost base if the nature of the expenses can properly be characterised as costs that were incurred to acquire a CGT asset or that 'relate' to a CGT event under paragraph 110-35(1)(b) of the ITAA 1997. For example, legal expenses which can be added to the second element of the cost base include those incurred as a result of the following events:

• purchasing or selling your property
• resisting land resumption
• defending your title to the property.

In your case, the legal expenses relate to a private dispute between you and the Plaintiffs. They do not relate to expenses incurred to acquire the property or expenses incurred that relate to a CGT event (in your case the disposal of the property).

As the expenses relate to the private agreement between you and the Plaintiffs, rather than matters pertaining to the acquisition, sale, or ownership of the property itself, no portion of the legal expenses that you incurred will form part of the second element of the CGT cost base of your property under subsection 110-25(3) of the ITAA 1997, nor will they meet the description of any of the other four elements of the CGT cost base noted above.