Private ruling: Rental property expenses deduction
Date of advice: 17 June 2016
Published: August 2016
Ruling period: Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019
Date scheme commenced: 1 July 2015

Ruling: Questions and answers | 1. Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the special levy raised by your local council for building a revetment wall on the beach to protect your rental property? | No | 2. Are you entitled to a deduction under section 43-10 of the ITAA 1997 for the special levy raised by your local council for building up a revetment wall on the beach to protect your rental property? | No | 3. Will the special levy raised by your local council be included in the fourth element of the cost base under section 110-25 of the ITAA 1997? | Yes

Relevant facts and circumstances: You own a rental property. Your local area experienced the effects of a prolonged high tide storm event as a result of climate change. Following that event, several owners of properties formed a Landholders Group (the Group) as a result of concerns about the continuing trend of erosion and the potential impact of that erosion on the adjacent residential properties. Your local council considered the Group's concerns and proposal and agreed to instigate an investigation which included consultation with relevant State agencies and coastal specialists. Your local council has approved a Protection Project. The council will start the construction of the Beach Revetment Wall adjacent to properties. The revetment wall will be entirely constructed on Council land and no part of it will touch your property. Your local council will be the owner of the revetment wall and consequently will be responsible for any maintenance or repairs, including sand nourishment, and public liability. You and other affected property owners have agreed to recover the initial construction cost via a special rate to be levied annually by your local council. The financial contribution required for your property is a once off payment or annually payments for several 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 Section 43-10 | Income Tax Assessment Act 1997 Section 110-25

Reasons for decision: Summary: 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 assessable income, except where the outgoings are of a capital, private or domestic nature, or relate the earning of exempt income. A number of significant court decisions have determined that, for an expense to satisfy the tests in section 8-1 of the ITAA 1997: • it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income producing expense ( Lunney & Hayley v. Federal Commissioner of Taxation (1958) 100 CLR 478; (1958) 7 AITR 166; (1958) 11 ATD 404) • there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income ( Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15;(1949) 4 AITR 236; (1949) 8 ATD 431); and • it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income ( Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; (1956) 11 ATD 147 (1956); 6 AITR 379; FC of T v. Cooper (1991) 29 FCR 177; 91 ATC 4396; (1991) 21 ATR 1616; Roads and Traffic Authority of NSW v. FC of T (1993) 43 FCR 223; 93 ATC 4508; (1993) 26 ATR 76; Federal Commissioner of Taxation v. Hatchett (1971) 125 CLR 494; 71 ATC 4184; (1971) 2 ATR 557). In your case, you use the property as a rental property; the relevant assessable income is the rental income. Your local council will build a revetment wall on the beach adjacent to your property; the revetment wall is intended to protect your rental property from erosion caused by the climate change. Your local council will raise a special levy on you and other affected property owners to cover the initial construction cost; the special levy is payable by a series of annual payments or a one off payment. It is considered that the character of the advantage sought and the manner, in which it is to be used, is that of a lasting benefit, that does not directly contribute to the means by which you earn the relevant assessable income (renting out the property). Also, as the character of the benefit obtained from paying the special levy is not part of the ordinary or constant demands, the special levy is not considered to be incidental and relevant to earning the relevant assessable income. Accordingly, the special levy will not be deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Capital Works Deductions: Section 43-10 of the ITAA 1997 provides that you can deduct an amount for capital works for an income year if: a) the capital works have a construction expenditure area; and b) there is a pool of construction expenditure for that area; and c) you use your area in the income year in the way set out in Table 43-140 (Current year use). Note 2 to section 43-10 of the ITAA 1997 provides that amongst other things, the definition of 'your area' ensures that only owners and certain lessees of capital works, and certain holders of quasi-ownership rights over land on which capital works are constructed, can deduct an amount under this Division. As a capital works deduction is only available to construction expenditure incurred on land where the person has an ownership interest, and the revetment wall will be constructed entirely on council land, you are not entitled to a deduction for the special levy under section 43-10 of the ITAA 1997. | Detailed Reasoning - Cost Base: Section 110-25 of the ITAA 1997 provides general rules about cost base. Subsection 110-25(5) of the ITAA 1997 provides that the fourth element of a CGT asset's cost base is capital expenditure incurred: a) the purpose or the expected effect of which is to increase or preserve the asset's value; or b) that relates to installing or moving the asset. ATO Interpretative Decision ATO ID 2012/46 Income Tax Capital Gains Tax: cost base: fourth element of cost base considers the issue of whether an underground power levy paid by a taxpayer forms part of the cost base of the taxpayer's property under subsection 110-25(5) of the ITAA 1997. The decision concludes that the levy will form part of the fourth element of the cost base of the property if the purpose or the expected effect of the expenditure is to increase or preserve the property's value. Whilst the factual situation is slightly different in the present case, it is considered that the same principles can be applied: Subsection 110-25(5) of the ITAA 1997 provides that the fourth element of the cost base of a CGT asset is that capital expenditure incurred to increase the asset's value. Expenditure incurred for capital improvements to post-CGT land will not be included in the cost base of the land if the capital improvement is considered to be a separate CGT asset. As neither of subsection 108-70(1) or section 108-60 of the ITAA 1997 applies in relation to the cabling it is not a separate asset for CGT purposes. Subsection 108-70(1) of the ITAA 1997 does not treat the cabling as a separate asset because none of the balancing adjustments contained in section 108-55 of the ITAA 1997 apply to it. Section 108-60 of the ITAA 1997 will not apply in this case as the cabling is not a depreciating asset that is part of a building. For expenditure to be included in the fourth element of the cost base of an asset under subsection 110-25(5) of the ITAA 1997, it must be incurred 'to' enhance the value of the asset, that is, for the purpose of enhancing the value of an asset. It is immaterial whether or not the expenditure in fact enhances the value of the asset. In your case, as noted above, expenditure incurred for capital improvements to post-CGT land will not be included in the cost base of the land if the capital improvement is considered to be a separate CGT asset. It is therefore necessary to consider whether the revetment wall is considered a separate CGT asset. Section 108-70 of the ITAA 1997 deals with when a capital improvement is considered to be a separate asset. Subsection 108-70(1) provides that a capital improvement to land is taken to be a separate CGT asset from the land if one of the balancing adjustment provisions set out in subsection 108-55(1) applies to the improvement; that is, if a balancing adjustment under Subdivision 40-D or section 355-15 or 355-525 applies to the building or structure. As none of the balancing adjustments in subsection 108-55(1) apply to the revetment wall, it is not treated as a separate CGT asset. As also noted above, for expenditure to be included in the fourth element of the cost base of an asset under subsection 110-25(5) of the ITAA 1997, it must be incurred 'to' enhance the value of the asset. The Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 (the EM), which expanded the scope of subsection 110-25(5) states at paragraph 2.141: The first change is that it is no longer necessary that the purpose of the expenditure be to increase the asset's value. Instead, it is now sufficient that the purpose or expected effect be to increase or preserve the asset's value. An example of expenditure that would now qualify for inclusion in the fourth element would be legal and other expenses incurred to preserve the value of a rental property by opposing a nearby development that would adversely affect the rental property's value. Another example would be the costs incurred in unsuccessfully applying for zoning changes. The construction of the revetment wall is intended to protect properties in that area from erosion and other damage from the climate change. It is considered that the purpose or expected effect of the expenditure on the special levy to fund the revetment wall is to increase or preserve the property's value. As such, the special levy paid will form part of the cost base of your property under subsection 110-25(5) of the ITAA 1997. | Summary: It is considered that the construction of the revetment wall will create an enduring benefit to your property. Accordingly, the special levy will not be deductible under section 8-1 of the ITAA 1997 as it is capital in nature. Further you will not be able to deduct the special levy under section 43-10 of the ITAA 1997 as the capital construction will not happen on property you have an ownership interest in. However the amount will still be included in the calculation of any future capital gain or loss under the fourth element of the cost base as per section 110-25 of the ITAA 1997.