Edited version of private advice

Authorisation Number: 1052276319336

Date of advice: 22 July 2024

Ruling

Subject: Rental property repairs

Question 1

Is the cost of replacing a retaining wall located at a rental property an allowable deduction as a repair under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Can you deduct expenditure for capital works completed at the rental property under Division 43 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 2020

Relevant facts and circumstances

On DD MM 20XX, you purchased a property (the property).

The property was purchased as an investment.

The property included a retaining wall which had been part of the property for 40 years.

The property was rented out a hundred percent of the time to a tenant.

On DD of MM 20XX, an extreme weather event occurred whereby two storm cells collided in the sky above which caused the wall to fall over. You did not see the wall fall over as you were working. You were informed that the retaining wall had fallen over due to the amount of water that landed around the wall. You proceeded to preparations of replacing the wall straight away due to the hazard it caused to the tenants renting the property as well as the surrounding neighbours.

On DD MM 20XX, the fallen wall and remaining broken parts of the wall were removed and taken to the tip.

Between the period of DD MM 20XX to DD MM 20XX construction of the wall commenced. The length of time was drawn out due to the workers not being able to finish from the poor weather conditions.

You incurred the following expenses in rebuilding the retaining wall:

•         $XX to remove the broken wall

•         $XX to rebuild the wall

•         $XX for the engineer's certificate

This brought the total cost to $XX.

You had to remortgage and borrow an extra $XX onto your existing mortgage on the property and redraw an extra $XX from another mortgage on another property to pay for the wall. You also had to exhaust your savings to make the balance.

You would have left the wall as it was if the weather event did not happen. Replacement of the wall was only completed due to the work health and safety hazard that the event caused.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 section 995-1

Does IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidancerule for income tax'.

Reasons for decision

An expense is deductible under section 8-1 of the Income Tax Assessment Act (ITAA 1997) if and to the extent which it is incurred in gaining or producing your assessable income or in carrying on a business for that purpose. However, you cannot claim a deduction for an expense that is capital, private or domestic in nature.

A deduction is only allowable if an expense:

•         is actually incurred

•         meets the deductibility tests

•         satisfies the substantiation rules.

Repairs

Section 25-10 of the ITAA 1997 generally allows a deduction for expenditure incurred on repairs to premises or plant held or used by a taxpayer for the purpose of producing assessable income. However, a capital expenditure is not deductible under section 25-10 of the ITAA 1997.

Taxation Ruling 97/23 Income tax: deductions for repairs (TR 97/23) explains the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10.

TR 97/23 states that in its context in section 25-10, 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.

Expenditure incurred for repairs is not deductible under section 25-10 if the expenditure is of a capital nature. TR 97/23 states that 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 for work that is a renewal in the sense of a reconstruction of the entirety.

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). In Lindsay's 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.

Property is more likely to be an entirety, as distinct from a subsidiary part, if (TR 97/23):

•         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.

TR 97/23 states that a reconstruction of the whole of property (for example, fencing or a railway) is not a deductible repair. The ruling states:

"Replacement or substantial reconstruction of the entirety, as distinct from the subsidiary parts of the whole, is an improvement."

The issue of repairs to retaining walls has been considered in a number of cases, including Case S13, 85 ATC 171 and Mt Isa Mines Ltd v FC of T 90 ATC 4267.

In Case S13, two retaining walls built on a rental property to prevent soil erosion were each held to be an 'entirety'. The replacement following storm damage, with two new retaining walls which were higher, stronger and of different material, was held to be an improvement to a fixed capital asset and not repairs.

In Mt Isa Mines Ltd v Federal Commissioner of Taxation, a mining company constructed a retaining wall to create a tailings dam on a mine site. The retaining wall was intended to be the first stage of a much larger development. Following seepage through the retaining wall a new retaining wall, or embankment, was constructed with the result that the old retaining wall was submerged. The Federal Court held that the expenditure incurred in building the new retaining wall was not deductible because it was an outgoing of capital or of a capital nature and did not constitute repairs to the old retaining wall or to the dam.

Your expenditure on replacing the retaining wall is not a deductible repair under section 25-10 ITAA 1997 because the whole retaining wall was replaced, making it a reconstruction of the entirety. The cost of replacing an entire retaining wall with a new retaining wall is of a capital nature. However, a deduction may be available under the capital works provisions under Division 43 of the ITAA 1997.

Deduction for Capital Works

Division 43 provides a deduction for construction expenditure on capital works (including buildings) used for residential accommodation if the construction of the capital works commenced after 17 July 1985 and the capital works are used to produce assessable income. The rate of deduction is 2.5% of the capital expenditure able to be deducted over 40 years. However, construction expenditure excludes expenditure on plants. Therefore, a deduction for expenditure on plants is not available under Division 43.

Division 43 applies to capital works that are buildings or structural improvements and to extensions, alterations or improvements to those buildings or structural improvements. If an item in a residential rental property is capital works then generally a deduction will not be available under Division 40 unless the item is both plant and depreciating asset and the other conditions of Division 40 are met.

In your case the wall is considered to be a capital works expense and you are entitled to a capital works deduction under Division 43 for 2.5% of the cost of the installation in your rental property over 40 years, while the property is rented or available to rent.

Note: the amount you can claim each year will need to be apportioned in accordance with your legal interest in the property.