Edited version of private advice

Authorisation Number: 1052184600764

Date of advice: 8 December 2023

Ruling

Subject: Rental deductions - repairs

Question

Question 1

Is expenditure incurred for the work carried out in Table A deductible under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes, to the extent that the work is completed and the cost has been charged to the Special Levy fund, your share of the expense is deductible for the income year.

Question 2

Is expenditure incurred for the work carried out in Table B deductible under Division 43 of ITAA 1997?

Answer

Yes, to the extent that the work is completed and the cost has been charged to the Special Levy fund, your share of the expense is deductible under Division 43 of the ITAA 1997.

This ruling applies for the following period:

Year ended 30 June 2023

The scheme commenced on:

1 July 2022

Relevant facts and circumstances

You purchased the property at XXXX on XX XX XX.

The building is 60-70 years old and in close proximity to the harbour.

The Property has been rented out since XX XX XX.

The property requires repairs as a result of water ingress from failed flashings, blocked gutters/down pipes and storms.

The gutter was corroded and the direction of fall would not effectively direct storm water away in the event of heavy and continuous rain.

Part of the scope of the work for the roof works was to supply access scaffolding.

Table A - your share of the expense related to:

Table 1 Share of Expenses Detailed

Table B - your share of the expense related to:

Table 2 Share of Expenses Detailed.

The strata corporation established a Special Levy.

The Special Levy fund is to enable the works described in Table A and Table B to be undertaken.

The work has not been completed as of XX XX XX, but the total cost of the works has been charged and paid by way of special levy.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 subsection 25-10(1)

Income Tax Assessment Act 1997 subsection 25-10(3)

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 section 43-20

Income Tax Assessment Act 1997 section 43-70

Income Tax Assessment Act 1997 subsection 43-70(1)

Income Tax Assessment Act 1997subsection 43-70(2

Reasons for decision

Issue 1

Questions 1 & 2

A deduction for the full amount of the special levy payment cannot be claimed in the income year in which the payment is made to the Special Levy fund. The whole of the special levy is not incurred in that income year. Further, it must be determined whether the various expenditures actually incurred were a deductible repair or capital expenditure. To the extent that the work is completed and the cost has been charged to the Special Levy fund your share of the expense in relation to Table A repair items is deductible under section 25-10 and items in Table B are deductible under Division 43 of ITAA 1997.

Detailed reasoning

Under section 8-1 of ITAA 1997 you can deduct 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. You have rental income and can claim certain rental expenses as a deduction.

Subsection 25-10(1) of the ITAA 1997 allows a deduction for the cost of repairs to premises, or a part of the premises, used solely for income-producing purposes. However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs that are considered capital expenditure. Division 43 of the ITAA 1997 allows deductions for capital works expenditure.

The following are examples of expenses which are capital expenditure or of a capital nature:

•         replacement of an entire structure or unit of property (such as a complete fence or building, a stove, kitchen cupboards or refrigerator),

•         improvements, renovations, extensions, and alterations, and

•         initial repairs, for example, in remedying defects, damage or deterioration that existed at the date you acquired the property.

Taxation Ruling TR 97/23 Income tax: deductions for repairs (TR97/23) 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.

Repair costs are deductible where they are incurred during the period the property is held for income producing purposes and are attributable either to damage that occurs during your income producing use of the property or to defects that emerge suddenly during that time.

Entirety

Renewal, replacement, or reconstruction of, the whole or substantially the whole of a thing or structure entirety is likely to be considered a capital improvement rather than a deductible repair.

The term 'entirety' is used by the courts in repair cases to refer to something 'separately identifiable as a principal item of capital equipment' (Lindsay v FC of T (1960) 106 CLR 377 at 385; (1960) 12 ATD 197 at 201 (the Lindsay case)).

In the Lindsay case, the taxpayer company was a slip proprietor and ship repairer. It claimed a deduction for the cost of reconstructing one of two slipways. In finding that the work was not repairs, Kitto J rejected the taxpayer's submission that either the whole slip (comprising the slipway, hauling machines, cradles, and winches by which vessels were manoeuvred on to it) or the whole of the business premises containing the slipway should be regarded as the relevant entirety. His Honour decided that the slipway was an entirety by itself and not a subsidiary part of a larger whole.

In the case of WG Thomas & Co Pty Ltd v FC of T (1965) 115 CLR 58; (1965) 14 ATD 78, which involved a claim for general repairs to a building, it was said that the question was not whether the roof or floor or some other part of the building, looked at in isolation, was repaired as distinct from wholly reconstructed, but whether what was done to the floor, or the roof was a repair to the building.

Relevantly, paragraph 40 of TR 97/23 describes a building as the entirety, and something that is part of the building, such as a roof or wall is considered to be a subsidiary part rather than the entirety.

Property is more likely to be an entirety, as distinct from a subsidiary part, if:

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.

Repair is distinct from improvement

Paragraphs 44 to 47 of TR 97/23 discuss improvements. An improvement provides a greater efficiency of function in the property. 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.

Paragraph 46 states: 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 consider, 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.

Paragraphs 48 to 52 of TR 97/23 discuss the use of different materials. In particular, paragraphs 49 and 50 provide:

49. Whether the use of a more modern material to replace the original material qualifies as a repair is a question determined on the facts of each case. It is restoration of a thing's efficiency of function (without changing its character) rather than exact repetition of form or material that is significant.

50. If the work done restores a previous function to the property, or restores the efficiency of the previous function, it does not matter that a different material is used. Even if the work done using different material enables the property to perform its function marginally more efficiently, the work may still constitute a deductible repair. However, the greater the work enhances the efficient functioning of the property, the more likely it is that the work constitutes an improvement.

Repairs and improvements effected concurrently

Paragraphs 55 to 57 of TR 97/23 discuss repairs and improvements effected concurrently. If repair work is inextricably bound up with work of an improvement nature, and the repair cannot be separately segregated, and its cost accurately quantified independently from the cost of improvements, we regard the cost of the entire work as being of a capital nature and not deductible.

For example, if work normally regarded as a repair such as painting is done to property as part of or in conjunction with a reconstruction and modernisation of the property and it cannot be segregated and its cost separately quantified it may not be deductible. It is a question of fact and degree.

Initial repairs

Initial repairs are of a capital nature and not deductible. At paragraphs 59 to 61 of TR 97/23:

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.

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.

Maintenance Work - whether "repair"

If you are preventing or fixing deterioration of an item that occurred while renting out your property, this is likely to be maintenance. For example, getting faded interior walls repainted of having a deck re-oiled. This should be claimed at Repair and Maintenance on the rental schedule.

Paragraphs 19 and 20 of TR 97/23 discuss work done to remedy or make good defects, damage or deterioration does not cease to be a repair if it is also done partly-even largely to prevent defects in their very early stages. Repairs are not confined to rectifying defects, damage or deterioration that have already become serious. Work done to property not in need of repair, however, is not repair work and any expenditure for the work in these circumstances is not deductible under section 25-10 of the ITAA 1997.

Some kinds of maintenance work are 'repairs' in terms of section 25-10, for example, painting plant or business premises to rectify existing deterioration and to prevent further deterioration. Other kinds of maintenance work, such as oiling, brushing or cleaning something that is otherwise in good working condition and only requires attention to prevent the possibility of its going wrong in the future, are not 'repairs' in terms of the section. Expenditure on the latter kind of maintenance work may be an allowable deduction under section 8-1.

Paragraphs 92 to 95 of TR 97/23 further consider when maintenance, or work done in anticipation of forthcoming defects or deterioration can be considered a repair if it is done in combination with work of rectification see the BP Oil Refinery (Bulwer Island) Ltd case at 92 ATC 4039; 23 ATR 73. As initially discussed at paragraph 20 of TR 97/23, Oiling, brushing or cleaning something that is otherwise in good working condition and only requires attention to prevent the possibility of its going wrong in the future, is not 'repairs' in terms of section 25-10: compare London & North Eastern Ry. Co. v. Berriman [1946] 1 All ER 255 at 267 and the BP Oil Refinery (Bulwer Island) Ltd case. (The cost of these operations may be deductible under section 8-1.)

Capital works

In some situations, depending on what the expenditure was for, initial repair expenses may be classified as capital works. Capital works is a term used to describe certain kinds of construction expenditure on buildings, structural improvements, extensions and alterations.

Division 43 of the ITAA 1997 provides a deduction for capital works. Under Division 43 of the ITAA 1997, a deduction for capital works is dependent, among other things, on whether there is 'construction expenditure' for the capital works, which is defined in subsection 43-70(1) of the ITAA 1997 as 'capital expenditure incurred in respect of the construction of capital works'.

Taxation Ruling TR 97/25 Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements addresses a number of matters that are relevant in determining entitlement to, and the amount of, a deduction under Division 43 of the ITAA 1997 in respect of expenditure on the construction of assessable income producing buildings and other capital works. It also identifies certain expenses that are included in construction expenditure.

Paragraph 7 of TR 97/25 outlines the three categories of capital works in respect of section 43-20 of the ITAA 1997 as:

•         Buildings or extensions, alterations or improvements to buildings

•         Structural improvements or extensions, alterations or improvements to structural improvements; and

•         Environment protection earthworks.

The Rental properties 2023 guide provides on page 26 the following examples of construction expenditure:

•         a building or an extension, for example, adding a room, garage, patio or pergola

•         alterations, such as removing or adding an internal wall, or

•         structural improvements to the property, for example, adding a gazebo, carport, sealed driveway, retaining wall or fence.

Subsection 43-70(2) of the ITAA 1997 lists a number of expenditures that are excluded from the definition of construction expenditure. Relevantly:

Construction expenditure does not include:

(a) expenditure on acquiring land; or

(b) expenditure on demolishing existing structures; or

(c) expenditure on clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation works; or

(d) expenditure on landscaping; or

(e) expenditure on *plant; or

(f) expenditure on property for which a deduction is allowable, or would be allowable if the property were for use for the *purpose of producing assessable income, ...

If the conditions are satisfied, capital works deductions may be claimed. In the case of residential rental properties, the deductions would generally be spread over a period of 25 or 40 years.

Expenditure for repairs must be 'incurred'

There need be no legal obligation on the taxpayer to undertake repairs for the taxpayer to be entitled to a deduction. Expenditure for the repairs must be 'incurred' by the taxpayer in the year of income in which the deduction is claimed. The word 'incur' in section 25-10 has the same meaning as the word 'incurred' in section 8-1.

Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions sets out the Commissioner's views on the meaning of incurred. The ruling outlines rules, settled by case law, which assist in defining when an outgoing is incurred.

Generally, an entity incurs an expense at the time they owe a present money debt that they cannot escape. That is for an expense to be incurred, there must be a presently existing liability to pay a pecuniary sum. The entity must be definitively committed to the expense in the year of income for the expense to be incurred. Presently existing liability is determined on the circumstances of the case, and especially by reference to the terms of the contract or agreement entered into.

The High Court in Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 27 ALJ 481; [1953] ALR 903; (1953) 10 ATD 240; (1953) 88 CLR 492 (James Flood) at (CLR 506) provided that a loss or outgoing will be incurred where the taxpayer is definitely committed or has completely subjected themselves to the loss or outgoing.

Dixon J in New Zealand Flax Investments Ltd v. Federal Commissioner of Taxation (1938) 12 ALJ 313; [1939] ALR 1; (1938) 5 ATD 36; (1938) 61 CLR 179 (New Zealand Flax) stated the term incurred, does not include a loss or expenditure which is no more than impending, threatened, or expected.

Barwick CJ in Nilsen Development Laboratories Pty Ltd v. Federal Commissioner of Taxation (1981) 144 CLR 616; (1981) 55 ALJR 97; (1981) 33 ALR 161; (1981) 81 ATC 4031; (1981) 11 ATR 505 (Nilsen Development) cited with approval the decision of Dixon J in New Zealand Flax. Barwick CJ in Nilsen Development provided that an impending, threatened, or expected loss or outgoing is not deductible, no matter how certain it is in the year of income that that loss or expenditure will occur in the future.

Claiming a deduction.

Payments to a special purpose fund set up by the body corporate to cover the cost of capital improvements or repairs of a capital nature into which funds are paid are not immediately deductible. However, you may be able to claim a repair or capital works deduction for your share of the expense once the work is completed and the cost has been charged to the fund. The amount that may be claimed at this time will depend on whether the expense incurred is attributable to a repair pursuant to section 25-10 of the ITAA 1997 or capital works under Division 43 of the ITAA 1997.

Application to your circumstances

The work items set out in Table A are considered to be repairs under section 25-10 of the ITAA 1997. Your share of the expenditure in relation to the completion of those repairs and charged to the Special Levy fund is deductible in that income year.

The cost in relation to the works set out in Table B are not considered to be a repair. The installation of the gutter guard and storm water drainage are capital works. These works enhance the efficient functioning of the property by increasing dissipation of storm water from the building. Once the work has been completed and is charged to the Special Levy fund a capital works deduction, under Division 43 of the ITAA 1997, for your share of the expenditure in relation to those expenses will be able to be claimed.