Private ruling: Capital gains tax - rental property - compensation
Date of advice: 18 August 2015
Published: August 2015
Ruling period: Income year ending 30 June 2013.
Date scheme commenced: 1 July 2012.

Ruling: Q1: Is the amount of the insurance settlement sum relating to building costs considered to be capital proceeds from the occurrence of a capital gains tax event in accordance with Part 3-1 of the Income Tax Assessment Act 1997 ? | A1: No. | Q2: Is the amount of the insurance settlement sum for rebuilding costs considered to be capital proceeds from the occurrence of a capital gains tax event in accordance with Part 3-1 of the Income Tax Assessment Act 1997 ? | A2: No. | Q3: Will the rebuilding costs be included in your cost base of the property? | A3: No.

Relevant facts and circumstances: You and your spouse jointly purchased a rental property (the property) after 20 September 1985. You and your spouse took out an insurance policy on the property. You and your spouse spent an amount of money renovating the property a number of years after it was purchased. The property incurred damage during a flood a number of years after it had been purchased. The property sustained damage to the internal cladding, electrical wiring, walls and gyprock. No damage had occurred to the structure of the property, the roof or the external walls. The property was not condemned, but was unliveable due to the flood damage. You and your spouse lodged an insurance claim in respect of the flood damage to the property. Your insurance provider agreed to accept the claim and had agreed to pay an insurance settlement sum (Settlement Sum) which included amounts for: • building sum insured • removal of debris • professional fees; and • loss of rent. The Settlement Sum was paid in two instalments with the first being paid around three months after the flood and the second payment around four months after the flood. You and your spouse spent some of the Settlement Sum to clean up the property and to restore the electricity to the property (rebuilding costs) within a few months of the flood occurring. You have provided copies of documents which should be read in conjunction with, and forms part of the scheme of this private ruling.

Relevant legislative provisions: Income Tax Assessment Act 1997 Part 3-1 | Income Tax Assessment Act 1997 S ubsection 20-25(1) | Income Tax Assessment Act 1997 S ubsection 20-25(2) | Income Tax Assessment Act 1997 Section 102-20 | Income Tax Assessment Act 1997 Subsection 110-45(3)

Reasons for decision: Detailed Reasoning - Capital gains tax: The capital gains tax (CGT) provisions are contained in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (ITAA 1997). They provide that you can only make a capital gain or a capital loss if a CGT event happens in accordance with section 102-20 of the ITAA 1997. Generally, any capital gain or capital loss should be apportioned in according to the legal ownership of the CGT asset unless the legal and equitable interests are not the same. Compensation for permanent damage to, or permanent reduction in the value of, the underlying asset Taxation Ruling TR 95/35 sets out the CGT consequences when a taxpayer receives a compensation payment. One of the receipt types it addresses is 'compensation for permanent damage to, or permanent reduction in the value of, the underlying asset'. The term 'permanent damage or reduction in value' is defined in paragraph 3 of TR 95/35 as not meaning an everlasting damage or reduced value, but damage or value reduction which will have permanent effect unless some action is taken by the taxpayer to put it right. In applying the 'look through' approach to determine the underlying asset to which the payment relates, paragraph 6 states: If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset. Paragraphs 7 and 8 discuss the consequences of the recoupment, and have direct application to the calculation of the cost base of an asset in terms of subsection 110-45(3) of the ITAA 1997, recouped expenditure. These paragraphs state: 7. Accordingly, the total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition costs (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount. 8. The adjustment of the total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred … Paragraph 133 of TR 95/35 outlines that if the amount of recoupment exceeds the taxpayer's total acquisition costs at the time of the compensation the effect is to reduce the costs to zero. The excess of the recoupment over the costs in these circumstances does not represent a taxable capital gain derived from the disposal of that asset. There are no CGT consequences in respect of any excess. It follows that the whole consideration received on a later actual disposal of that asset by the taxpayer will be a taxable capital gain (unless the taxpayer incurs additional expenditure which forms part of the cost base of that asset). Where the compensation received relates to a property acquired after 19 September 1985 (post CGT) then using the look through approach, if the compensation relates to permanent damage to it, or a permanent reduction in its value, then the cost base of the asset is reduced accordingly. Subsection 110-45(3) of the ITAA 1997 outlines that expenditure does not form part of the cost base to the extent that any amount you have received as recoupment of it, except so far as the amount is included in your assessable income. Application to your situation In your situation, the rental property you and your spouse jointly own was damaged in a flood and required extensive repairs. You and your spouse put in an insurance claim and received a Settlement Sum which consisted of amounts for the following: • building sum insured • removal of debris • professional fees; and • loss of rent. You and your spouse spent some of the Settlement Sum to clean up the property and to engage the services of an electrician to restore power to the property (rebuilding costs). The facts of your case indicate that your property suffered damage during the flood that caused a permanent damage which reduced the value of the property. Applying TR 95/35 to your situation, it is viewed that the property is the underlying asset. No CGT event occurred in the income year in which the Settlement Sum was received. Therefore, as no CGT event had occurred at the time of the receipt of the Settlement Sum, there is no assessable capital gain in terms of Division 104 of the ITAA 1997. However, while you did not make a capital gain upon the receipt of the Settlement Sum, we have considered the CGT consequences arising as a result of the receipt of the Settlement Sum as follows: You and your spouse each have an ownership interest in the property and you each have your own cost base for the property. The Settlement Sum you and your spouse received needs to be apportioned in accordance with your ownership interest in the property. You and your spouse did not suffer a loss of the property, nor have you disposed of the property. However, the damage to the property resulted in permanent reduction in the value of the property. We consider that the Settlement Sum was received in respect of the permanent damage to the property and that amount will represent a recoupment of part of the acquisition cost of the property. The rebuilding costs you and your spouse paid to clean-up of the property and engage the services of an electrician, the rebuilding costs, had been sourced from the Settlement Sum. Therefore, it cannot form part of any element of the cost base of the property and is also viewed as a recoupment. Therefore, this amount will also be included with the amount of building costs to reduce you and your spouse's cost bases in the property at the time the Settlement Sum was received. Your share of the recoupment amounts, being your share of the building costs and the rebuilding costs will reduce your cost base in the rental property. Based on the information provided with the private ruling, your cost base for your share in the property is less than your share of the Settlement Sum. Therefore, your cost base will be reduced to nil. The excess amount of the Settlement Sum does not represent a taxable capital gain and there are no CGT consequences in respect of the excess. Note: Your share of expenses incurred in relation to the property after the Settlement Sum was paid can be included in your cost base if you have not claimed a deduction for them, or can claim a deduction for them.