Edited version of private advice

Authorisation Number: 1052218098418

Date of advice: 14 May 2024

Ruling

Subject: Rental property - income and deductions

Question 1

Are the expenditures you incurred in relation to the works carried out on your water damaged rental property deductible repairs under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes. However, only certain expenditures are considered deductible repairs. Refer to reasons for decision for full details.

Question 2

Are the insurance payouts that you received assessable as ordinary income under section 6-5 of the ITAA 1997?

Answer

No.

Question 3

Is the amount of the insurance payouts received for deductible repairs regards as an assessable recoupment under section 20-20 of the ITAA 1997?

Answer

Yes.

Question 4

Is the amount of insurance payouts received for capital allowances or capital works an assessable recoupment under section 20-20 of the ITAA 1997?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You acquired a property located at AA in 20XX.

You provided us with details about the property at the time of acquisition.

Following the acquisition of the Property, you rented the Property.

On a specified date the hot water pipe in the ceiling of the Property burst resulting in water damage to the ceilings, walls, carpets, floors, cabinets and appliances.

You lodged an insurance claim on the same day.

On a specified date you received authority to proceed with repairs from BB.

Due to the timeframe from the date of the damage to receiving authority to proceed with repairs, mildew had occurred in the walls, ceilings and floors.

All ceilings (except for the living room), all internal wall plaster, insulation, cabinetry, appliances, lighting, timer flooring, carpet and heating flooring in bedrooms were affected. All affected areas were taken back to the frames.

You stated that the insurance company engaged BB to do the necessary work and the insurance company paid BB directly when the works were completed.

The kitchen, laundry and bathroom cabinetry restoration work were not done by BB as they were going to be lower quality materials compared to the original quality. You agreed with the insurance company on a specified date to receive a payout for a similar quality and engage your own contractor to complete the repairs.

You provided us with details on the amount you received from your insurance company and the date of payment. You organised your own kitchen company to install a similar quality cabinetry to the original kitchen and laundry.

You requested that you receive a partial payment from the insurance company for the remainder of the restoration work to be completed. You provided us with details on the payments that you received.

The partial payments were used for both replacement and improvements to restore the Property.

You provided us with details on the expenditures that you have incurred.

You provided us with details on the improvements that you made to the property.

At the time of this ruling the property is still undergoing repairs.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 section 40-30

Income Tax Assessment Act 1997 Division 43

Reasons for decision

Question 1

Are the expenditures you incurred in relation to the works carried out on your water damaged rental property deductible repairs under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Detailed reasoning

Deduction for repairs

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to the property used for income producing purposes.

However, expenses which are capital, or of a capital nature are not deductible as repairs or maintenance. The following are examples of expense 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 alternations, 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 explains the circumstances in which deductions for repairs are allowable under section 25-10 of the ITAA 1997.

TR 97/23 states that in its context in section 25-10 of the ITAA 1997, the word 'repairs' has its ordinary meaning. It ordinarily 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.

Rental property damage

In Wulf v FC of T [2022] AATA 3094 (Wulf), the AAT considered at length existing case law along with the guidance provided in TR 97/23 to arrive at a conclusion that some of the expenditures incurred by the taxpayer on their rental property were repair expenses whilst some other expenditures were capital improvements. The rental property was subject to water damage and the bathroom, ensuite and kitchen were completely rebuilt with contemporary new fittings and cabinetry. It was found that the rooms had been modernised from what it was prior to the water damage occurring. As a result, the materials on modernising the rooms were considered a capital expenditure whilst the other materials were considered repairs. The fact that the works were necessary was not a major concern.

Application to your circumstances

Your circumstances are similar to those in Wulf where there was water damage to various rooms in the property. Whilst some of the work conducted on your Property were to restore the damaged area to its previous condition, some of the work were in the nature of an improvement where the damaged area was rebuilt with contemporary new fittings to modernise the Property from what it was prior to the water damage. As a result, we have considered that some items are capital expenditure whilst other items would be considered repairs.

We provided you with details on which expenses that you have incurred would qualify as repairs.

Decline in value (Capital Allowances)

Section 40-25 of the ITAA 1997 allows a deduction for the decline in value of a depreciating asset that you hold. A depreciating asset is an asset that can reasonably be expected to decline in value over time it is used (section 40-30 of the ITAA 1997).

Depreciating assets are those items that can be described as plant, which do not form part of the premises. These items are usually: separately identifiable; not likely to be permanent and expected to be replaced within a relatively short period and not part of the structure. Examples of assets that deductions for decline in value can be applied to include: timber floorings, carpets, curtains, appliances like a washing machine or fridge and furniture.

Application to your circumstances

We provided you with details on which expenditures that you have incurred would qualify as capital allowances and are not deductible as repairs.

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.

The rate of deduction for capital works for a residential property is 2.5% of construction expenditure over 40 years.

Application to your circumstances

We provided you with details on which expenditures that you have incurred would qualify as capital works and are not deductible as repairs.

Question 2

Are the insurance payouts that you received assessable as ordinary income under section 6-5 of the ITAA 1997?

Summary

As the insurance payments that you received are in relation to damages to your rental property and not for the loss of income, the payments are not assessable as ordinary income under section 6-5(2) of the ITAA 1997.

Detailed reasoning

Ordinary income

Section 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes the ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Rent is regarded as ordinary assessable income, however your insurance payout does not relate to rent or other ordinary income. As the insurance payments you received as not for loss of income, the payments are not assessable as ordinary income under subsection 6-5(2) of the ITAA 1997.

Question 3

Is the amount of the insurance payouts received for deductible repairs regards as an assessable recoupment under section 20-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The insurance payments that you received that relates to deductible repairs to your rental property, is an assessable recoupment and forms part of your assessable income.

Detailed reasoning

Statutory income

Amounts that are not ordinary assessable income but are included in your assessable income by another provision is called statutory income (section 6-10 of the ITAA 1997). The provisions dealing with statutory income are listed in section 10-5 of the ITAA 1997. Included in this list is subdivision 20-A of the ITA 1997 (assessable recoupments).

Assessable recoupment

Under subsection 20-20(2) of the ITAA 1997, an amount received as a recoupment of a loss or outgoing is an assessable recoupment if:

a.            you received the amount by way of insurance or indemnity; and

b.            you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it for an earlier income year, under any provision of this Act.

Section 25-10 of the ITAA 1997 provides that expenditure incurred on repairs to a rental property are deductible.

Therefore, an amount received by way of insurance is an assessable recoupment if it is paid to cover the cost of repairs to a rental property and the deduction can be claimed in the current year or in an earlier year.

Application to your circumstances

The insurance payouts you received that relates to deductible repairs to your rental property is an assessable recoupment and forms part of your assessable income.

Question 4

Is the amount of insurance payouts received for capital allowances or capital works an assessable recoupment under section 20-20 of the ITAA 1997?

Summary

The insurance payments that you received that relates to capital allowances or capital works deductions for your rental property, is not an assessable recoupment and are not assessable under any other provision of the ITAA 1997. Therefore, these insurance payments do not form part of your assessable income.

Detailed reasoning

Under paragraph 20-20(2)(b) of the ITAA 1997, a recoupment of a loss or outgoing is only an assessable recoupment if you can deduct an amount for the loss or outgoing for the current year, or has deducted or is able to deduct an amount for it for an earlier income year, under any provision of the ITAA 1997.

The phrase "for the loss or outgoing" in paragraph 20-20(2)(b) of the ITAA 1997 requires a connection between the deduction and the loss or outgoing for which the taxpayer had been recouped.

In your case, the relevant loss or outgoing includes an amount for the destruction of the capital items.

Whilst you may be able to deduct an amount in relation to the original construction of the capital works under section 43-40 of the ITAA 1997, or in relation to a future construction of replacement of capital works under section 43-10 of the ITAA 1997, these are not deductions for the loss referred to in paragraph 20-20(2)(b) of the ITAA 1997. No outright deduction is available for the loss of the capital allowances or capital works.

Application to your circumstances

The insurance payouts that relate to the capital allowances and capital works deductions for your rental property is not an assessable recoupment under section 20-20 of the ITAA 1997. Additionally, the insurance payouts are also not assessable under any other provisions of the ITAA 1997.