Private ruling: Rental property expenses - undeducted construction expenditure
Date of advice: 5 March 2020
Published: April 2020
Ruling period: Year ended 30 June 2019 | Year ended 30 June 2018
Date scheme commenced: 1 July 2017

Ruling: Q1: Are you entitled to a deduction for your share of the undeducted construction expenditure for that part of the property that was destroyed during the renovations? | A1: Yes. | Q2: Are you entitled to a deduction for your share of the balancing adjustment deductions for the depreciating assets that were destroyed during the renovations? | A2: Yes. | Q3: Are you entitled to a deduction for your share of rental property expenses while the property was being renovated? | A3: Yes. | Q4: Are you entitled to your share of the capital works deductions for the new construction expenditure from the date you vacated the property? | A4: Yes. | Q5: Are you entitled to a deduction for your share of the decline in value of the new depreciating assets from the date you vacated the property? | A5: No.

Relevant facts and circumstances: You purchased an investment property prior to 1 July 2017 and immediately rented it out. You renovated the property after 1 July 2017. The renovations included demolishing substantial areas of the original building, constructing new capital works and removing and replacing depreciating assets. The property remained vacant during the entirety of the renovation. Your intention was to readvertise the property for rent once the renovation work had been completed; however, as it transpired you moved into the property. You later moved out of the property and rented it out. You continued to incur expenses during the time the property was being renovated. There were undeducted amounts remaining for both capital works and depreciating items at the time of demolition. You did not receive any salvage amounts for the removal of the capital works or the depreciating assets contained within the property.

Relevant legislative provisions: Income Tax Assessment Act 1997 section40-25 | Income Tax Assessment Act 1997 section40-27 | Income Tax Assessment Act 1997 section 40-85 | Income Tax Assessment Act 1997 subsection 40-285(2) | Income Tax Assessment Act 1997 section 40-295 | Income Tax Assessment Act 1997 section 40-300 | Income Tax Assessment Act 1997 section43-10 | Income Tax Assessment Act 1997 section43-20 | Income Tax Assessment Act 1997 section43-25 | Income Tax Assessment Act 1997 section43-40 | Income Tax Assessment Act 1997 section43-140 | Income Tax Assessment Act 1997 section43-160 | Income Tax Assessment Act 1997 section43-210 | Income Tax Assessment Act 1997 section43-250

Reasons for decision: Summary: Division 43 of the ITAA 1997 sets out the rules for working out deductions for capital expenditure on assessable income producing buildings and other capital works. Section 43-40 of the ITAA 1997 states that you can deduct an amount if all or a part of your area is destroyed in an income year and: (a) you have been allowed, or can claim, a deduction under this Division, or former Division 10C or 10D of Part III of the Income Tax Assessment Act 1936 , for your area; and (b) there is an amount of undeducted construction expenditure for your area; and (c) you were using your area in the way that applied to it under Table 43-140 (Current year use) immediately before the destruction or if not, neither you nor any other entity used your area for any purpose since it was last used by you in that way. The Commissioner considers that section 43-40 of the ITAA 1997 applies both to voluntary and involuntary destruction of capital works (paragraph 18 of 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 ). You have previously claimed a deduction for construction expenditure and there is an amount of undeducted construction expenditure for your area. As the requirements of paragraphs 43-40(1)(a) and (b) of the ITAA 1997 have been satisfied the issue to be considered is whether paragraph 43-40(1)(c) of the ITAA 1997 has been satisfied. Paragraph 43-40(1)(c) of the ITAA 1997 has two limbs. The first limb is satisfied if 'your area' was used immediately before the destruction in a way that applies to it under the table in section 43-140 of the ITAA 1997. The required use for a house is that it is used for the purpose of producing assessable income. If it has not been used for this purpose, then the second limb allows a deduction if no entity has used the area for any purpose since it was last used by the taxpayer for the purpose of producing assessable income. In considering if the requirements of paragraph 43-40(1)(c) of the ITAA 1997 are satisfied the meaning of 'immediately before the destruction' must be considered. Section 43-160 of the ITAA 1997 is also relevant in this consideration, which provides that a part of your area is taken to be used, for use or available for use for a particular purpose at a time if, at that time: · it was maintained ready for use for that purpose · it was not used or for use for any other purpose, and · its use or intended use for that purpose had not been abandoned. In your circumstances, you decided to demolish part of the property in order to undertake renovations. It is considered that immediately before the destruction occurred the property had been used for income producing purposes and your intention was to maintain the use of the property for this purpose. Further, neither you nor any other party used the property for any other purpose. Therefore, you are entitled to a deduction for your share of the undeducted construction expenditure under subsection 43-40(1) of the ITAA 1997. Section 40-25 of the ITAA 1997 allows a deduction for the decline in value (depreciation) of a depreciating asset you hold, to the extent the asset is used for a taxable purpose. Taxable purpose includes for the purpose of producing assessable income. A balancing adjustment event occurs for a depreciating asset if you stop holding the asset or you stop using it, or having it installed ready for use, for any purpose and you expect never to use it, or have it installed ready for use, again (section 40-295 of the ITAA 1997). As a result, you may have to make an adjustment to your taxable income. Subdivision 40-D of the ITAA 1997 allows a balancing adjustment deduction in certain circumstances. Subsection 40-285(2) of the ITAA 1997 provides that you can deduct an amount if: a) a balancing adjustment event occurs for a depreciating asset you held; and (i) whose decline in value you worked out under Subdivision 40-B; or (ii) whose decline in value you would have worked out under that Subdivision if you had used the asset; and b) the asset's termination value is less than its adjustable value just before the event occurred. The amount you can deduct is the difference between those amounts, and you can deduct it for the income year in which the balancing adjustment event occurs. The termination value of a depreciating asset is worked out as at the time when the balancing adjustment event occurs. 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, Column three of the table in subsection 40-300(2) of the ITAA 1997). The adjustable value of a depreciating asset at a particular time is: a) if you have not yet used it or had it installed ready for use for any purpose - its cost; or b) for a time in the income year in which you first use it, or have it installed ready for use, for any purpose - its cost less its decline in value up to that time; or c) for a time in a later income year - the sum of its opening adjustable value for that year and any amount included in the second element of its cost for that year up to that time, less its decline in value for that year up to that time (subsection 40-85(1) of the ITAA 1997). In your case, a balancing adjustment event occurred when parts of the building were demolished which included some depreciating assets. You did not receive any amounts for the salvage of the depreciating assets that were removed from the property or destroyed during the renovations. As the termination value of the depreciating assets was less than their respective adjustable values you are entitled to a deduction for your share of the differences under subsection 40-285(2) of the ITAA 1997 in the year ended 30 June 2018. Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing your assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. It is not necessary that the expenditure in question should produce assessable income at the same time or even in the same year in which the expenditure is incurred. Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities in considering the decision of the High Court in Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's Case) provides that interest will be incurred in gaining or producing assessable income, including where: · the interest is not private or domestic · the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost, and · the interest is incurred with one end in view, the gaining or producing of assessable income. While Steele's Case dealt with the issue of interest, the principles can be applied to other types of expenditure including local council, water and sewerage rates, electricity and gas, land taxes and emergency services levies. In your case, your intentions during the period the property was being renovated were to continue to use the property to produce assessable income. It was only due to your change in circumstances that you moved into the property. On that basis, at the time you incurred the expenditure to renovate the property there was no private or domestic purpose for holding the property, your intention was always to build an income producing property. Therefore, you are entitled to a deduction for expenses such as local council, water and sewage rates, land taxes and emergency services levies under section 8-1 of the ITAA 1997 during the period the property was undergoing renovations and was not deriving rental income. Division 43 of the ITAA 1997 allows a deduction for certain capital expenditure on the construction of income producing buildings and other capital works. The deduction amount depends on when the construction started and how the capital works are used. No amount can be claimed before the completion of construction of the capital works. You can only claim a capital works deduction if: a) the capital works have a construction expenditure area b) there is a pool of construction expenditure for that area, and c) the taxpayer uses the area in the income year in the way set out in the table in section 43-140 of the ITAA 1997 (section 43-10 of the ITAA 1997). Using your capital works to produce assessable income is a relevant use for the purposes of being able to claim a deduction for those capital works (section 43-140 of the ITAA 1997). Your area is taken to be used, for use or available for use for a particular purpose or in a particular manner at a time if, at that time: a) it was maintained ready for use for that purpose or in that manner b) it was not used or for use for any other purpose or in any other manner; and c) its use or intended use for that purpose or in that manner had not been abandoned (section 43-160 of the ITAA 1997). In your case, you are not entitled to a capital works deduction during the period you lived in the property even though you were advertising it for rent. This is because you were using the property for private purposes. However, from the date that you vacated the property, the property is considered to have been maintained for the purposes of producing assessable income and was not being used for any other purpose. As such, you are entitled to a capital works deduction under subsection 43-10 of the ITAA 1997 from the date you vacated the property. Division 40 of the ITAA 1997 contains the rules that apply to most depreciating assets. It explains what a depreciating asset is, when you start deducting amounts for depreciating assets and how to work out your deductions. You can deduct an amount equal to the decline in value for an income year of a depreciating asset to the extent that it is used for a taxable purpose (subsection 40-25(1) of the ITAA 1997). You must reduce your deduction by the part of the asset's decline in value that is attributable to your use of the asset, or your having it installed ready for use, for a purpose other than a taxable purpose (subsection 40-25(2) of the ITAA 1997). In addition, following the introduction of new rules from 1 July 2017, you may have to further reduce your deduction for certain second-hand depreciating assets in a residential rental property (section 40-27 of the ITAA 1997). Second-hand depreciating assets includes depreciating assets previously installed ready for use or used in your private residence. Subsection 40-27(2) provides that you must reduce your deduction by any part of the asset's decline in value that is attributable to your use of it, or your having it installed ready for use, for the purpose of producing assessable income: a) from the use of residential premises to provide residential accommodation; but b) not in the course of carrying on a business; a. If: c) You did not hold the asset when it was first used, or first installed ready for use, (other than as trading stock) by any entity; or d) at any time during the income year or an earlier income year, the asset was used, or installed ready for use, either: (i) in residential premises that were one of your residences at that time; or (ii) for a purposes that was not a taxable purpose, and in a way that was not occasional. Paragraph 40-27(2)(d) of the ITAA 1997 concerns depreciating assets that were used, or installed ready for use, for any other purpose prior to the assets being used in residential premises to provide residential accommodation. In your case, the depreciating assets that were installed in the property during the renovations would satisfy paragraph 40-27(2)(c) of the ITAA 1997, being that they were purchased new and not second-hand. However, at the time when you started to use the property to produce assessable income from renting it out after you used it as your residence, the depreciating assets had been previously used. Therefore, you are not entitled to a deduction for the decline in value of those depreciating assets under section 40-25 of the ITAA 1997 as section 40-27 of the ITAA 1997 will operate to reduce your deduction to nil.