Private ruling: Rental property - improvements - repairs - legal expenses
Date of advice: 16 September 2016
Published: November 2016
Ruling period: Year ended 30 June 2014 | Year ended 30 June 2015 | Year ended 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018
Date scheme commenced: 1 July 2013

Ruling: Q1: Are you entitled to a deduction for your share of the expenses incurred to underpin and stabilise the concrete slab of your rental property? | A1: No. | Q2: Are you entitled to a deduction for your share of the expenses incurred to repair damage to the property that has occurred to the building itself due to the defective slab and foundations? | A2: Yes. | Q3: Are you entitled to a deduction for your share of legal expenses incurred to recover the cost of remedying the defective concrete slab and foundations? | A3: No. | Q4: Are you entitled to a deduction for your share of legal expenses incurred to recover the cost of repairing damage to the property that has occurred to the building itself due to the defective slab and foundations? | A4: Yes.

Relevant facts and circumstances: You and your spouse acquired land as tenants in common and engaged the services of a builder to construct a building on it. The property has been rented or available for rent since completion. Cracks became evident in the walls of the building. Engineering tests identified that the slab and foundations had been under designed, and has led to localised movement and distortions to the slab which in turn has resulted in damage to the building itself. To rectify the defects in the slab and foundations, and to prevent further damage to the building, the foundations need to be underpinned. You will incur expenses for this remedial work to be completed. You will also incur expenses to repair the damage to the building itself. You incurred legal fees to pursue the builder and the engineering firm who prepared the foundation design to try and recover the cost of the remedial works required. The original dispute through the district court was settled and you were paid as per Terms of Settlement

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 25-10 | Income Tax Assessment Act 1936 subsection 160ZH(11)

Reasons for decision: Detailed Reasoning - Deductibility of remedial costs: You can deduct expenditure you incur for repairs to premises that you used solely for the purpose of producing assessable income providing the expenditure is not capital in nature (section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)). The word 'repair' is not defined within the income tax legislation and therefore takes its ordinary meaning. It ordinarily means the remedying or making good of defects in, damage to, or deterioration of property to be repaired. Repairs involve the restoration of a thing to a condition it formerly had without changing its character (W Thomas & Co v. FC of T (1965) 115 CLR 58; (1965) 14 ATD 78; (1965) 9 AITR 710). Osborn's Concise Law Dictionary , 8th edition, defines 'repair' as: 'The making good of defects in a property which has deteriorated from its original state. The work required may involve curing defects arising from the defective design or construction of the building, but it must fall short of effectively reconstructing the premises or improving them.' Expenditure is capital in nature where the work undertaken goes beyond a repair and becomes an improvement. An improvement provides a greater efficiency of function and involves bringing property into a more valuable or desirable form, state or condition than a mere repair would do. Expenditure for repairs is also of a capital nature where the extent of the work carried out represents a renewal or reconstruction of an entirety, or where the work is done to repair damage or deterioration in existence at the date of acquisition of property (that is, an initial repair). In your case, the remedial work is not considered to represent a renewal or reconstruction of an entirety (the entirety being the Building itself), and as you engaged a builder to construct the building the works are not considered to be initial repairs. The work done to fix the damage to the building itself does no more than return the building to the state it was in before the problems with the slab and foundations became apparent. As such, you are entitled to a deduction for your share of the expenditure incurred for this work under section 25-10 of the ITAA 1997. However, the work done to underpin and stabilise the slab and foundations goes beyond restoring the property to its original state and alters the character of the property. After this work is completed the foundations and slab will be stronger and perform better than those originally constructed, resulting in a greater efficiency of function to the property. As such, the underpinning and stabilisation of the slab is an improvement rather than a repair, and therefore the expenditure incurred for this work is capital in nature and not deductible under section 25-10 of the ITAA 1997. | Detailed Reasoning - Deductibility of legal expenses: You can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income except where the loss or outgoing is capital or private in nature (section 8-1 of the ITAA 1997). In determining whether a deduction for legal expenses is allowable the nature of the expenditure must be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. Where the object of the expenditure is devoted towards a revenue purpose, the legal expenses are deductible (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; [1932] HCA 56; (1932) 2 ATD 169). In your case, you have incurred legal expenses to recover the cost of repairs (a deductible revenue expense) and the cost of improvements (a non-deductible capital expense), as identified above. As such, you are entitled to a deduction for your share of the legal expenses incurred to recover the cost of repairs under section 8-1 of the ITAA 1997. The legal expenses incurred to recover the cost of improvements are capital in nature and not deductible. | Detailed Reasoning - Apportionment: The apportionment of legal expenses is dealt with in Taxation Determination TD 93/29 Income tax: if an employee incurs legal expenses recovering wages paid by dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 . This determination provides that where legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature, there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income. Where a solicitor's account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim. | Detailed Reasoning - CGT treatment of settlement proceeds: The treatment of compensation payment received for permanent damage to, or permanent reduction in the value of, the underlying asset is dealt within the Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts . It provides when an amount of compensation is received wholly in respect of permanent damage suffered to or reduction in the value of a post-CGT underlying asset of the taxpayer, with no disposal of the asset at the time of receipt, than the amount represents a recoupment of all or part of the total acquisition costs of the asset. As per subsection 160ZH(11) of ITAA 1936, the total acquisition costs of the post-CGT asset should be reduced by the compensation amount. Further, no capital gain or loss will arise in respect of the asset until the asset is disposed. 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. For your case, you are yet to dispose your asset even after the settlement date. The settlement amount that you received should be treated as if this amount has never incurred, reducing your total acquisition costs by the same amount. There will be no CGT consequences arising from receiving the compensation amount.

Question 1: Will the settlement proceeds reduce the cost base of the property and form part of any future capital gain/loss on the property?