Edited version of private advice

Authorisation Number: 1052338805968

Date of advice: 9 December 2024

Ruling

Subject: Capital Works

Question 1

Can you claim an immediate deduction for work carried out at your rental property?

Answer

No, as the work undertaken is capital in nature.

Question 2

Can you claim a capital works deduction under Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997) for work carried out at your rental property, excluding demolition expenses and costs associated with purchasing and installing depreciating assets (as defined in section 40-30 of the ITAA 1997)?

Answer

Yes.

Question 3

Did a balancing adjustment event under section 40-295 of the ITAA 1997 occur with respect to depreciating assets (as defined in section 40-30 of the ITAA 1997) that were lost or destroyed?

Answer

Yes. Depending on any insurance, compensation or sale proceeds received you may have an amount to include in your assessable income, or an amount to deduct from your income.

Question 4

Can you claim a deduction for the undeducted construction expenditure (as calculated under Subdivision 43-G of the ITAA 1997) relating to any lost or destroyed capital works?

Answer

Yes, to the extent that the undeducted construction expenditure relates to the capital works that have been destroyed. The deduction is reduced by amounts you have received or have a right to receive for the destroyed works.

Question 5

In calculating the deduction for destroyed capital works, are any proceeds received for disposing of property that was part of the destroyed works reduced by demolition expenses?

Answer

Yes. Section 243-255 of the ITAA 1997 provides that when working out the amounts you have received or have a right to receive for the destroyed capital works, amounts you received for disposing of property are reduced by any demolition expenditure on that property.

This ruling applies for the following periods:

Year ending 30 June 20xx

Year ending 30 June 20xx

The scheme commenced on:

xx xxx 20xx

Relevant facts and circumstances

You acquired an investment property (the Property) about 10 years ago. You have used it as a residential rental property solely for income producing purposes since purchase.

The tenants vacated the Property when the most recent lease ended. On attending the Property you found it to be in a severe state of disrepair including:

•                     Electrical wiring pulled from walls

•                     Holes in walls, doors, balustrades and other fixtures

•                     Broken locks

•                     Flooring torn and intentionally damaged

•                     Broken bathroom fittings

•                     Cracked tiles

Significant repairs were required leading to a range of expenses including:

•                     Demolition works

•                     Replacement of walls

•                     Replacement of depreciating assets

•                     Replacement of fixtures

•                     Plumbing and electrical work

•                     Site management and labour

•                     Council fees

•                     Fees related to drafting a new strata bylaw

The total of the expenses is $xxx,xxx, incurred across two income years.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 section 40-30

Income Tax Assessment Act 1997 section 40-285

Income Tax Assessment Act 1997 section 40-295

Income Tax Assessment Act 1997 section 40-300

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Subdivision 43-G

Income Tax Assessment Act 1997 section 43-40

Income Tax Assessment Act 1997 section 43-70

Income Tax Assessment Act 1997 section 43-250

Income Tax Assessment Act 1997 section 43-255

Reasons for decision

Question 1

Can you claim an immediate deduction for work carried out at your rental property?

Summary

A specific deduction for repairs to depreciating assets or premises used to produce assessable income is available under section 25-10 of the ITAA 1997, however no deduction can be claimed for capital expenses. A general deduction under section 8-1 of the ITAA 1997 is available for expenses incurred in the course of earning assessable income, but only to the extent the expense is not capital in nature.

As the work performed at your property is capital in nature, no deduction is available under either of the above provisions.

Detailed reasoning

Repairs

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises used for income producing purposes, provided the expenditure is not capital in nature. Section 8-1 of the ITAA 1997 allows a deduction for expenses you have incurred in earning assessable income, to the extent that it is not capital in nature.

Taxation Ruling TR 97/23 - Income tax: deductions for repairs explains the circumstances in which deductions for repairs are allowable. Paragraph 21 provides, a repair for the purposes of section 25-10 is a question of fact and degree in each case having regard to the appearance, form, state, and condition of the particular property at the time the expenditure is incurred and to the nature and extent of the work done to the property. The ruling also provides that repairs mean the remedying or making good of defects in, damage to, or deterioration of, property.

The word 'repairs' is not defined in the legislation so takes its ordinary meaning. A repair ordinarily means the remedying or making of good of defects in, damage to, or deterioration of, property to be repaired. 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, where:

•                     the extent of the work carried out represents a renewal or reconstruction of the entirety;

•                     the works result in a greater efficiency of function in the property, therefore representing an 'improvement' rather than 'repair';

•                     the thing or structure is brought into a more valuable or desirable form when an initial repair would do.

Paragraph 123 of TR 97/23 provides that a repair restores the efficiency of function of the property, without changing its character, regardless of whether the same material as the original is used. An improvement, on the other hand, provides a greater efficiency of function in the property. It involves bringing a thing or structure into a more valuable or desirable state or condition than a mere repair would do.

Renewal or replacement

Buckley LJ in Lurcott v Wakely & Wheeler [1911] 1 KB 905 at 924, in paragraph 113 of TR 97/23 provides:

'Repair is restoration by renewal or replacement of subsidiary parts of a whole. Renewal, as distinguished from repair, is reconstruction of the entirety, meaning by the entirety not necessarily the whole but substantially the whole subject-matter under discussion... the question of repair is in every case one of degree, and the test is whether the act to be done is one which in substance is the renewal or replacement of defective parts, or the renewal or replacement of substantially the whole.'

TR 97/23 provides that to repair property improves to some extent the condition it was in immediately before repair. A minor and incidental degree of improvement, addition or alteration may be done to property and still be a repair. However, if the work amounts to a substantial improvement, addition, or alteration, it is not a repair and is not deductible under section 25-10.

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.

Entirety

The term 'entirety' is used by the court 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 (the Lindsay case).

In the Lindsay case, the High Court considered whether the replacement of a slipway was a repair or replacement of an entirety. The court held that the slipway was the relevant entirety on the ground and that it was not a subsidiary part of anything else but was separately identifiable as a principal item of capital expenditure.

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 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.

In Case W77 89 ATC 698; (1989) 20 ATR 3888 the owner of a rental property was denied a deduction for a remodelling of a bathroom, amongst other expenditure, where repair was required due to the age, deterioration and general wear and tear. It was held that the work done in remodelling the bathroom was extensive and could be described as a complete renovation designed to improve the unit rather than simply to restore it.

In your case, the works carried out to the unit were extensive and can be described as a complete renovation. Although the work was carried out to remedy damage by tenants, the work involved demolition, rebuilding and replacement of fixtures and assets, and as such amounted to a substantial improvement. Therefore, the expenditure is capital in nature and is not a deductible 'repair' under sections 25-10 or 8-1 of the ITAA 1997.

Question 2

Can you claim a capital works deduction under Division 43 Income Tax Assessment Act 1997 (ITAA 1997) for work carried out at your rental property, excluding demolition expenses and costs associated with purchasing and installing depreciating assets (as defined in section 40-30 ITAA 1997)?

Summary

Division 43 of the ITAA 1997 provides for a deduction to be claimed over 40 years for expenditure on capital works in a construction expenditure area used for the purposes of producing assessable income.

Detailed reasoning

Division 43 of the ITAA 1997 provides a deduction for capital works attributable to a construction expenditure area that is owned or leased by the taxpayer and used during the income year for the purposes of producing assessable income. Capital works includes buildings and structural improvements and also extensions, alterations, or improvements to buildings.

The deduction is calculated with reference to your construction expenditure, being capital expenditure incurred in respect of the construction of the capital works. This includes indirect expenditure, like drafting a strata bylaw, to the extent that it relates to your capital works; refer to taxation ruling TR 97/25 Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements.

Section 43-70 of the ITAA 1997 provides that certain types of expenses are not considered construction expenditure, including demolition expenses and plant. Taxation ruling TR 2004/16 Income tax: plant in residential rental premises gives the ATO view on what constitutes plant in rental properties, being items of machinery or articles that do not form part of the premises. A deduction for the decline in value of these items will generally be available under Division 40 of the ITAA 1997. Further guidance on specific assets can be found in the ATO guide Rental Properties.

Question 3

Did a balancing adjustment event under section 40-295 ITAA 1997 occur with respect to depreciating assets (as defined in section 40-30 ITAA 1997) that were lost or destroyed?

Summary

A balancing adjustment event occurred in respect of any depreciating assets that were lost or destroyed through the actions of the tenants or as part of the works undertaken at the property.

Detailed reasoning

Under paragraph 40-295(1)(a) of the ITAA 1997 a balancing adjustment event occurs for a depreciating asset if the taxpayer stops holding the asset. A taxpayer will stop holding a depreciating asset in various circumstances including when it is lost or destroyed.

The termination value of a depreciating asset that has been lost or destroyed is provided by Item 8 in the table in subsection 40-300(2) of the ITAA 1997 and is the amount you received or receivable under an insurance policy for the loss or destruction.

The adjustable value of a depreciating asset at the time of the loss or destruction is its opening adjustable value for the income year, less any decline in value for the income year up until that time.

Subsection 40-285(1) of the ITAA 1997 provides that if the termination value is greater than the adjustable value, the difference between the two amounts is included in your income as assessable income.

Subsection 40-285(2) of the ITAA 1997 provides that if the termination value is less than the adjustable value, you can deduct the difference between the two amounts.

Question 4

Can you claim a deduction for the undeducted construction expenditure (as calculated under Subdivision 43-G ITAA 1997) relating to any lost or destroyed capital works?

Question 5

In calculating the deduction for destroyed capital works, are any proceeds received for disposing of property that was part of the destroyed works reduced by demolition expenses?

Summary

You can claim a deduction for any undeducted construction expenditure that relates to the capital works that have been lost or destroyed. The deduction is reduced by any amounts you have received as a consequence of the destruction.

Detailed reasoning

Section 43-40 of the ITAA 1997 provides for a balancing deduction where there has been a destruction of capital works. The deduction is calculated under section 43-250 of the ITAA 1997 which provides that the deduction will be so much of the undeducted construction expenditure that relates to the part of the capital works area that was destroyed, less any amounts you have received or have a right to receive for the destruction of that part.

Section 43-255 of the ITAA 1997 provides that the amounts you have received or have a right to receive includes:

•                     Amounts received under an insurance policy for the destruction

•                     Amounts received for disposing of property in the destroyed area, less any demolition expenses.

Demolition expenses can only reduce amounts received for disposing of property (not amounts paid under insurance policies) and can only reduce those amounts to zero (there is no further reduction if the demolition expenses exceed the amounts received for disposal). For further explanation see ATO Interpretive Decision ATO ID 2003/833 Income Tax - Capital works: demolition expenditure and deduction for destruction.

As only the amount of undeducted construction expenditure that relates to the destroyed area can be claimed as a balancing deduction, it may be necessary to use the services of a quantity surveyor to aid in the calculation.