Edited version of private advice

Authorisation Number: 1052187419074

Date of advice: 8 November 2023

Ruling

Subject: Deductions - rental expenses

Question 1

Are amounts paid to a solicitor to appeal a refused insurance claim, in relation to your investment property, considered an allowable income tax deduction?

Answer 1

No.

Question 2

Are amounts paid to a building construction firm to prepare a causation report to support your appeal to the insurer, in relation to your investment property, considered an allowable income tax deduction?

Answer 2

No.

Question 3

Do the cost of the repairs, solicitors cost to appeal a refused insurance claim and building causation report cost form part of the cost base, of your investment property, for capital gains tax (CGT) purposes?

Answer 3

Yes. To the extent that they are not covered by any insurance proceeds received.

This private ruling applies for the following periods:

Year ending 30 June 20

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You and your husband purchased an investment property at XX XX.

Settlement of the property occurred on XX XX 20XX.

The property had an existing tenant when you purchased the property.

You continued renting the property to the same tenant until they notified you of their intention to vacate the property on XX XX 20XX.

Whilst your tenant was renting the property, they lodged a maintenance request regarding water leaking from the ensuite shower as well as rotting walls on the adjoining bedroom and hallway on XX XX 20XX.

On XX XX 20XX a plumber conducted a leak detection test on the property which concluded water was leaking due to a failed waterproofing membrane.

You lodged a claim with your insurance company on XX XX 20XX.

The insurance company advised you that failed waterproofing was not covered under your policy, so you withdrew your claim.

Throughout XX 20XX to XX 20XX, you obtained private quotes to repair the damage to the ensuite and adjoining walls.

The quotes ranged from demolishing and replacing the entire bathroom, to demolishing and replacing the shower section only.

You signed a contract with a builder on XX XX 20XX to replace the shower section.

Your builder commenced demolition of the ensuite shower on X XX 20XX.

During the demolition process the builder subsequently advised due to the damage they would need to repair the entire bathroom and would need to revise their quote.

The builder advised the cause of the water damage was due to a cracked air conditioning drainpipe that ran between the ensuite and bedroom wall.

Your builder advised the following.

•         Significant damage had been done to many of the wall supports.

•         Cracked pipes are generally covered under insurance.

You contacted your insurer to lodge a claim.

The insurance company sent out their building company to assess the damage and determine the cause.

The insurance company denied your insurance claim in full on XX XX 20XX. They concluded that the damage was due to the waterproofing failure and not the cracked pipe.

Your builder suggested this decision was incorrect and the damage was caused by the cracked air conditioning drainpipe.

Your existing builder refused to become involved in any dispute with the insurance company.

You then engaged XX Building consultancy to obtain a causation report.

You also engaged solicitor to appeal the insurance company's decision.

XX building consultancy agreed with your original builder, they stated the damage was due to the air conditioning drainpipe which was cracked.

XX building consultancy determined the drainpipe had been leaking for years, possibly since construction and this had led to the waterproofing being undermined.

Your solicitor appealed the insurers decision on your behalf.

The insurance company upheld their denial decision on XX XX 20XX and referred the matter to internal dispute resolution (IDR) for further review.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 110-25 (5)

Reasons for decision

Deductions - Rental expenses

Question 1

Are amounts paid to a solicitor to appeal a refused insurance claim, in relation to your investment property, considered an allowable income tax deduction?

Question 2

Are amounts paid to a building construction firm to prepare a causation report to support your appeal to the insurer, in relation to your investment property, considered an allowable income tax deduction?

Question 3

Do the cost of the repairs, solicitors cost to appeal a refused insurance claim and building causation report cost form part of the cost base, of your investment property, for capital gains tax (CGT) purposes?

Summary

The cost incurred on the investment property for legal expenses and cost associated to obtaining a builder causation report can be characterised as an outgoing on revenue account or an outgoing of a capital nature depending on the cause or purpose for which they were incurred.

In your case the purpose for which you incurred legal expenses and the cost associated to the building report were because of a denied insurance claim.

The root cause that gave rise for the need for the insurance claim and the expenses you incurred to appeal the insurance company's decision was due to a fault which pre-existed when you purchased the property.

Consequently, these expenses will not be deductable as per section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) and are considered to be capital in nature.

These costs would constitute as an initial repair and can be included in your cost base as per section 110-25 of the ITAA 1997, to the extent that these expenses are not covered by any insurance proceeds received.

Detailed reasoning

Rental expenses - solicitor fees and cost for building causation report.

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.

Legal expenses can be characterised as an outgoing on revenue account or an outgoing of a capital nature depending on the cause or purpose for which the legal expenses were incurred.

Application to your circumstances

The expenses are capital in nature as they relate to the asset from which income is earned, rather than to part of the income-earning process.

The need for the solicitor (legal expense) and cost to obtain a causation report were due to a denied insurance claim.

Section 25-10 of the 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 following are examples of expenses which are capital 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

Your building causation report suggests the fault was pre-existing and most likely present at the time of construction and prior to purchase, so would be considered an initial repair.

Repairing damage that existed when the property was bought whether it was known at the time of purchase or not is considered initial repair.

Initial repairs

Taxation Ruling TR 97/23 Income tax: deductions for repairs, discusses initial repairs and paragraph 59 explains that an initial repair is not deductible under section 25-10. 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.

Paragraph 60 explains that 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.

In your case the defect existed at the time of acquisition of the property.

Paragraph 61 specifically considers the fact of whether a taxpayer was not aware of the need for repairs at the time of purchase. 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.

Application to your circumstances

In your case the expenses incurred for the solicitor's fee and the cost associated to obtaining a building causation report were incurred because of the dispute you had with your insurance company XX. They are capital in nature as they relate to the asset from which income is earned, rather than to part of the income-earning process.

The reason an immediate deduction cannot be claimed for your legal expenses and cost associated to obtaining a building report is due to the cause highlighted in the Your building consultancy causation report. The causation report suggests the fault was pre-existing and most likely present at the time of construction and prior to purchase making the expenses incurred (legal cost and cost for a building report) an initial repair.

Cost base

Subsection 110-25 of the ITAA 1997 provides capital expenditure incurred to increase or preserve the asset ' s value; can be included in the cost base of the asset.

Legal expenses which are capital in nature also form part of the cost base of your property for capital gains tax (CGT) purposes when you sell the property.

The first element of the cost base of a capital gains tax (CGT) asset is generally the cost of the asset when you bought it. However, it also includes certain other costs associated with acquiring, holding and disposing of the asset. The cost base of a CGT asset is made up of five elements. You need to add together all these elements to work out your cost base for each CGT asset.

Application to your circumstances

The expenses that you incurred can be said to meet the above description. As such, your combined expenses form part of the cost base of your property.

You acquired the property on XX XX 20XX. You were not aware of the cracked drainpipe at the time you acquired the property.

The cracked drainpipe is the main reason why you had to fix the ensuite and the main reason behind your legal fee and building causation report cost. Therefore, these costs would constitute as an initial repair and can be included in your cost base as per section 110-25 of the ITAA 1997.