Private ruling: Deductibility of repairs, undeducted capital expenditure and depreciating assets
Date of advice: 23 December 2021
Published: March 2022
Ruling period: Year ended 30 June 2021
Date scheme commenced: 1 July 2020

Ruling: Q1: Are costs incurred to repair your rental properties exceeding the insurance payout deductible under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: Are the undeducted capital expenditures from previous capital works destroyed deductible under section 43-40 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: Yes | Q3: Are the written down value of depreciating assets destroyed deductible under section 40-285 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A3: Yes

Relevant facts and circumstances: You own rental units within a unit complex. You purchased the properties nearly 10 years ago. The properties have been continually rented since then except for when repairs were carried out. A number of those properties were extensively damaged resulting from a leaking roof on the top level of the unit complex. A building inspection was carried out prior to the purchase of the properties with no pre-existing problems found. Repairs were carried out to rectify the damage to the properties including replacing previous capital works and depreciating assets that were destroyed by mould. The properties were not rented while the repairs were carried out. You provided reports from Company X outlining the extent of the damage to the properties and include works completed to treat and remove the problem. You received an insurance payout of $X to reimburse you for costs that you had already paid for to repair the damage to the properties. You incurred further costs of $Y to repair the damage. These costs were in addition to the insurance payout. You did not receive an insurance payment for the destruction of capital works or for the destroyed depreciating assets. You also did not receive insurance payments for the undeducted construction expenditure for those capital works destroyed and the undeducted written down amounts remaining for those depreciating assets. You have $D of undeducted construction expenditure from previous capital works. You have a total written down amount of $E for the destroyed depreciating assets.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 25-10 | Income Tax Assessment Act 1997 subsection 25-10(3) | Income Tax Assessment Act 1997 section 40-25 | Income Tax Assessment Act 1997 paragraph 40-85(1)(c) | Income Tax Assessment Act 1997 subsection 40-85(2) | Income Tax Assessment Act 1997 section 40-285 | Income Tax Assessment Act 1997 paragraph 40-285(1)(b) | Income Tax Assessment Act 1997 paragraph 40-285(2)(b) | Income Tax Assessment Act 1997 subsection 40-300(2) | Income Tax Assessment Act 1997 section 40-365 | Income Tax Assessment Act 1997 section 43-40 | Income Tax Assessment Act 1997 section 43-250 | Income Tax Assessment Act 1997 section 43-255 Question 1 | Summary | The works undertaken were due to damage resulting from a leaking roof. The properties were used to produce assessable income and they were rented at the time the issue arose. Therefore the cost of repairs is deductible under section 25-10 of the Income Tax Assessment Act (ITAA 1997). Detailed reasoning | Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to premises used for income producing purposes. However, under subsection 25-10(3) of the ITAA 1997 a deduction is not allowable for repairs where the expenditure is capital in nature. | Taxation Ruling TR 97/23 Income tax: deductionsfor repairs (TR 97/23) explains the circumstances in which repairs are allowable under section 25-10 of the ITAA 1997. | TR 97/23 states that the word 'repair' 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. TR 97/23 states that a 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. | Paragraph 36 of TR 97/23 further states that a repair is restoration by renewal or replacement of subsidiary parts of a whole. This is distinguished from renewal or reconstruction of the entirety. | Paragraph 38 of TR 97/23 provides that property is more likely to be an entirety 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 is 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. | Paragraph 39 of TR 97/23 considers that property is more likely to be a subsidiary part rather than an entirety if: | • it is an integral part of some larger item of plant; or | • the property is physically, commercially and functionally an inseparable part of something else. | In WG Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58 , it was considered that repairs to guttering, the roof, walls and floors of a building were subsidiary parts of a whole where the building itself was treated as the entirety. | However, expenditure for repairs to property is of a capital nature where the extent of the work carried out represents a renewal or reconstruction of the entirety. | Application to your circumstances | In your situation, you have owned the properties for some years and they have been rented consistently to tenants since with the exception of when repairs were carried out. The works undertaken were due to damage resulting from a leaking roof on the top level of the unit complex. The damage was not pre-existing when you purchased the properties. While you did receive an insurance payout for some of the repairs, you incurred additional costs to rectify the issue to bring the properties back to a state where they could be rented again. | Repairs are deductible where they are incurred during the time the property or properties are held for income producing purposes and the damage or defects occur during that time. | Your properties are used for income producing purposes and the work completed is not the replacement of an entirety, nor are they improvements. Therefore, you are entitled to claim a deduction for the repair costs that exceed the insurance payout under section 25-10 of the ITAA 1997. | Question 2 | Summary | You can deduct in the income year in which the capital works are destroyed, the amount of undeducted construction expenditure (called a balancing deduction) under section 43-40 of the ITAA 1997 provided that all conditions outlined in this provision are met. | You did not receive a payment from your insurer for the destruction of previous capital works. The capital works were used for income producing purposes before they were destroyed, and you are entitled to a capital works deduction. Therefore, the undeducted construction expenditure of the destroyed capital works is deductible under section 43-40 of the ITAA 1997. | Detailed reasoning | Section 43-40 of the ITAA 1997 allows a capital works deduction if all, or part of your capital works are destroyed in an income year provided that: | • you have been allowed, or can claim a capital works deduction for the capital works; and | • there is an amount of undeducted construction expenditure for the capital works; and | • the capital works were used for income producing purposes immediately before they were destroyed | The deductible amount is calculated using the method statement set out in section 43-250 of the ITAA 1997 where the deductible amount is equal to the undeducted construction expenditure for the destroyed capital works less amounts you have received or have a right to receive for the destruction of the capital works. This includes any amount received under an insurance policy and any salvage amount received for the capital works under section 43-255 of the ITAA 1997. | Application to your circumstances | In your circumstances, the properties were used for income producing purposes up until and immediately before the capital works were destroyed. You have undeducted construction expenditure remaining at the time the capital works were destroyed by mould | You did not receive a payment from your insurer for the destruction of the capital works or receive a payment for the capital expenditure not yet deducted. | Therefore, the undeducted construction expenditure is deductible under section 43-40 of the ITAA 1997. | Question 3 | Summary | A balancing adjustment event occurs when you stop holding a depreciating asset, including when it is destroyed. | You can deduct the difference where the insurance amount received for the destruction of a depreciating asset is less than its adjustable value. However, where the insurance amount received exceeds its adjustable value, the difference is included in your assessable income. | When you stop holding a depreciating asset involuntary, such as when it is destroyed, you may choose to include the balancing adjustment amount in your assessable income to offset the cost of the replacement asset. | Detailed reasoning | Under section 40-295 of the ITAA 1997, a balancing adjustment event occurs for a depreciating asset if you stop holding the asset, or when it is destroyed. | Paragraph 40-285(2)(b) of the ITAA 1997 provides that you can deduct an amount if the termination value of the depreciating asset is less than its adjustable value. This difference is deductible for the income year in which the balancing adjustment event occurs. | Paragraph 40-285(1)(b) of the ITAA 1997 provides that if the termination value of the depreciating asset is more than its adjustable value, the difference is included in your assessable income for the income year in which the balancing adjustment event occurs. | Calculating the balancing adjustment | The balancing adjustment amount is calculated by comparing the asset's termination value with its adjustable value outlined in section 40-285 of the ITAA 1997. | Where a depreciating asset is lost or destroyed, the termination value is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction (item 8 in the table in subsection 40-300(2) of the ITAA 1997). | The adjustable value of an asset is the opening adjustable value for that year and any amount included in the second element costs for the year, less its decline in value for the year up to that time (paragraph 40-85(1)(c) of the ITAA 1997). | The opening adjustable value of a depreciating asset for an income year is its adjustable value to you at the end of the previous income year (subsection 40-85(2) of the ITAA 1997). | Section 40-365 of the ITAA 1997 provides that when you stop holding a depreciating asset involuntary because it is lost or destroyed, you may choose to include the balancing adjustment amount in your assessable income to the extent that you choose to treat it as a reduction in the cost of the replacement asset. | Furthermore, you can only make this choice for a replacement asset if you incur the expenditure on the replacement asset or, you start to hold it: | • no earlier than one year, or within a further period the Commissioner allows, before the balancing adjustment event occurred; and | • no later than one year, or within a further period the Commissioner allows, after the end of the income year in which the balancing adjustment event occurred | Application to your circumstances | In your situation, a balancing adjustment event occurred when some depreciating assets you held were destroyed by mould. You did not receive a payment from your insurer for the destroyed depreciating assets and your insurer did not carry out or incur costs to replace the depreciating assets. | As the termination value of the depreciating assets is less than their adjustable values the difference is deductible under section 40-285 of the ITAA 1997.