Edited version of private advice

Authorisation Number: 1052275321872

Date of advice: 15 July 2024

Ruling

Subject: Deductions - legal expenses

Question

Can you deduct the legal expenses you have incurred to defend the right to re-instate an air-conditioner into your rental property pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2023

Year ending 30 June 2024

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You own an investment property (the Property) on a Strata Plan.

At an Annual General Meeting (AGM), the Owner's Corporation raised a special levy per each unit and appointed a builder to alleviate concrete Spalding from the building.

The work required major demolition and rebuilt, for this work the units were vacated.

In 20XX and 20XX, the front half of the Property, including your balcony, kitchen and lounge were demolished, to rectify the concrete Spalding.

After the works were complete, you were required to install a new kitchen and shutters that had been demolished.

XX months after the Property was vacated to rectify the concrete Spalding, you were able to re-tenant. You wanted to reinstate your split level air-conditioner.

In 20XX and 20XX, at an AGM for the Strata Plan, the Strata Committee approved the Bylaw with conditions for air-conditioners.

In 20XX, you wanted to install an air-conditioner, the Strata Committee rejected this request.

You attempted to pursue this matter with the Department of Fair Trading, the Strata Committee did not attend the mediation. You then took the matter to the State Civil and Administrative Tribunal (The Tribunal).

The Tribunal advised you to obtain further legal advice, planning advice and you incurred further administrative costs to address the issue of installing the air-conditioning.

You wish to install the air conditioner to make the Property more comfortable for tenants and to obtain market rate for rent.

The Property has been rented or genuinely available for rent during the relevant income tax years.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 110-25

Reasons for decision

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent to 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 the earning of 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 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.

If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. Expenditure is capital in nature where it is made with a view to bring into existence an asset or advantage that is of an enduring benefit. Capital expenditure is characterised by the fact that it is usually a one-off payment and establishes, replaces or enlarges an income producing asset.

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 a refrigerator);

•         Improvements, renovations, extensions and alterations, and

•         Initial repairs, for example, 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 principles and the circumstances in which expenditure incurred for repairs is an allowable deduction. Expenditure for repairs to property is capital expenditure if the expenditure, rather than being for work done to restore the property by renewal or replacement of subsidiary parts of a whole, is work that is a renewal in the sense of a reconstruction of an entirety.

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 or capital equipment' (Lindsay v FC of T (1960) 106 CLR 377 at 385; (1960) 12 ATD at 201 (the Lindsay case)).

Expenditure incurred for works to property will be capital in nature where the extent of the work carried out represents a renewal or reconstruction of an entirety. Paragraph 38 in TR 97/23 states that 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 itself from the thing or structure which it serves; or

•         The thing or structure is a 'unit of property' as that expression used in the depreciation deduction provisions of the income tax law.

Application to your circumstances

Legal expenses of a capital nature are not deductible under section 8-1 of the ITAA 1997, nor are legal expenses which are properly characterised as private expenses.

Non-deductible legal expenses may, however, form part of the cost base of your property for capital gains tax purposes.

In your case, the legal expenses were incurred as a result of legal proceedings regarding your right to install an air-conditioner into your rental property. The air-conditioner will produce an 'enduring benefit' and the legal expenses you have incurred are intended to preserve the income earning structure of the property.

Your expenses are of a capital nature and consequently, it is considered that the legal expenses are not deductible under section 8-1 of the ITAA 1997.

Section 110-25 of the ITAA 1997, provides the general rules about the cost base of a Capital Gains Tax (CGT) asset. Subsection 110-25(5) covers the fourth element of capital expenditure that you may incur. A capital expense can be included in the cost base of the property for CGT purposes, where the purpose or the expected effect of the expense is to increase or preserve the asset's value or relates to installing or moving an asset.