Edited version of private advice

Authorisation Number: 1052322928149

Date of advice: 24 October 2024

Ruling

Subject: Deductions - rental property expenses

Question 1

Can you deduct the costs associated with underpinning your rental property under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Can you claim capital works deductions for the expenses incurred to replace the retaining wall for your rental property, under Division 43 of the ITAA 1997, on completion of the works?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

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

The Property was your principal place of residence when acquired.

At the time of purchase, a Building and Pest Report was conducted, which did not evidence any structural damage or pest activity. However, the report noted conditions conducive to structural damage, emphasizing the need for ongoing maintenance.

From XX 20XX, the Property became a rental, producing assessable income for you. The Property has always been rented or available for rent from this point in time.

The following documents were provided by you, and are to be read with, the description of the facts and circumstances set out in this private ruling.

•         Building and Pest Report

•         Engineering Report

•         Extension and Repair Contract

On XX XX 20XX, you received an initial crack report from the tenant.

The Engineering Report identified:

•         a stepped crack in the single-skin brick wall

•         failure of mortared rock retaining wall and the crib retaining wall at the back of the property

•         poor landscaping and draining contributing to excessive moisture conditions

•         recommendations for underpinning to stabilise the structure.

The underpinning and installation of a retaining wall are essential to restore the structural integrity and to enable the Property to continue to earn rental income.

The current masonry block retaining wall was required to be repaired or completely replaced.

You have chosen to completely replace the retaining wall with concrete sleepers, in line with the engineering report recommendations.

The Extension and Repair Contract states the cost of the works was $XX,XXX.XX, which was broken down as follows:

•         deposit - $X,XXX.XX

•         completion of concreting underpins - $XX,XXX.XX

•         completion of jacking stage - $XX,XXX.XX

•         completion of retaining walls - $XX,XXX.XX.

It is anticipated that the works (completion of underpinning and retaining wall replacement) will be completed in the 20XX income year.

The Property is still being rented and earning assessable income, whilst the underpinning and retaining wall works are completed.

Your tenant's lease is due to end during the time allocated for the works, you intend that the Property will continue to be rented or available for rent.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 division 43

Reasons for decision

Question 1

Can you deduct the costs associated with underpinning your rental property under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The expenses you incurred to underpin parts of the property's concrete slab were completed to make good damage caused by the operation of natural causes (whether expected or unexpected) during the passage of time. As the underpinning work involved a restoration of efficiency of function, it was to bring the Property back to a liveable and safe condition without changing the appearance or character. The expenses are an allowable repair deduction under section 25-10 of the ITAA 1997.

Detailed reasoning

Repairs and improvements

When considering the costs incurred and subsequently any allowable deductions it is vital to distinguish between restoration of the item of property in question to its former condition (deductible) and improvement of the item (capital and thus not deductible).

Section 25 of the ITAA 1997 provides that expenditure incurred by you for repairs to any premises, or part of premises, held or used by you solely for the purpose of producing assessable income is an allowable deduction. However, subsection 25-10(3) of the ITAA 1997 precludes a repair deduction if the expenditure is of a capital nature. The following are examples of expenses which are capital expenditure or of a capital nature:

• Replacement of an entire structure or unit of property (for example 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 explains the principles and the circumstances in which expenditure incurred for repairs is an allowable deduction. TR 97/23 explains that 'repairs' has its ordinary meaning. It ordinarily means that remedying or making good of defects in, damage to, or deterioration of, property to be repaired and contemplates the continued existence of the property. To repair property improves to some extent the condition it was in immediately before the repair. If the work amounts to a substantial improvement, addition or alteration, it is not a repair and is not deductible under section 25-10 of the ITAA 1997.

It is necessary to consider whether the work done to property constitutes repairs by considering whether the work restores the efficiency of function of the property without changing its character. Repair is distinct from renewal or reconstruction; a repair is restoration by renewal or replacement of subsidiary parts of a whole. Renewal or reconstruction, as distinguished from repair, is restoration of the entirety.

Work done on part of a building, though not amounting to a replacement or reconstruction of an entirety may still be capital expenditure and not deductible, for example, because it amounts to an improvement. Paragraphs 44 to 57 of the TR 97/23 detail the distinction between a repair and an improvement.

An improvement provides greater efficiency of function in the property. It involves bringing a thing or structure into a more valuable and 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.

The character of a repair does not necessarily change because it is carried out at the same time as an improvement. If some parts of the project can be effectively separated and considered in isolation from the rest of the project, they may still be repairs

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 the conclusion that some of the expenditures incurred by the taxpayer on their rental property were expenses while some other expenditures were capital improvements. The rental property was subject to water damage. It was found that the works undertaken had modernised from what it was prior to the water damage occurring. As a result, the materials on modernising the property were considered capital expenditure whilst other materials were considered repairs.

In many repair processes, there is some improvement made to property as a result of technological advancements or more modern material. The greater the degree of technological advancement or enhancements arising due to the use of modern materials generally indicates the work completed is an improvement or change in the character of the property rather than a repair.

Application to your circumstances

The expenses you incurred to underpin parts of the property's concrete slab were completed to make good damage caused by the operation of natural causes (whether expected or unexpected) during the passage of time. As the underpinning work involved a restoration of efficiency of function, it was to bring the Property back to a liveable and safe condition without changing the appearance or character. The expenses are an allowable repair deduction under section 25-10 of the ITAA 1997.

Question 2

Can you claim capital works deductions for the expenses incurred to replace the retaining wall for your rental property, under Division 43 of the ITAA 1997, on completion of the works?

Summary

The replacement of the entire retaining wall is an improvement to the Property. Under Division 43 of the ITAA 1997, you are entitled to a capital works deduction for 2.5% of the cost of the installation in your rental property over 40 years, from the date construction is completed, and while the property is rented or available to rent.

Detailed reasoning

Capital works deductions

Division 43 of the ITAA 1997 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.

Division 43 applies to capital works that are buildings or structural improvements and to extensions, alterations or improvements to those buildings or structural improvements.

Division 43 of the ITAA 1997 provides that you can deduct an amount for capital works in an income year.

Subsection 43-10(2) of the ITAA 1997 states that you can only deduct the amount if:

(a)  the capital works have a construction expenditure area; and

(b)  there is a pool of construction expenditure for that area;

(c)   you use your area in the way set out in Table 43-140 (current use year).

The deduction can be claimed for 40 years from the date the construction is completed. The rate of deduction per income year is 2.5%.

Capital works also generally include improvements to buildings as stated in subsection 43-20(1) of the ITAA 1997.

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 (196) 106 CLR 377 at 385; (196) 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.

TR 97/23 details 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 on 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 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 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 a 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.

Application to your circumstances

In your case, the underpinning of the property and the improvement of the retaining wall is considered to be a capital works expense and you are entitled to a capital works deduction under Division 43 of the ITAA 1997, for 2.5% of the cost of the installation in your rental property over 40 years, from the date construction is completed, and while the property is rented or available to rent.