Private ruling: Rental property expenses
Date of advice: 23 November 2017
Published: April 2018
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Are you entitled to claim a capital works deduction for the expenses incurred in relation to the demolition of the garage and patio (including approvals, permits and building inspection costs)? | A1: No, however these costs may be included in your cost base for CGT purposes. | Q2: Are the costs incurred in relation to the construction of a new retaining wall located on your rental property (including obtaining approvals) allowable as a deduction for repairs under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: No. | Q3: Are the costs incurred in relation to the construction of a new retaining wall located on your rental property (including obtaining approvals) allowable as a capital works deduction calculated in accordance with Division 43 of the ITAA 1997? | A3: Yes. | Q4: Are you entitled to a deduction under section 40-755 of the ITAA 1997 for the expenses incurred specifically in relation to the removal of the asbestos in the retaining wall? | A4: Yes. | Q5: Are you entitled to claim a deduction under section 25-10 of the ITAA 1997 for the expenses incurred with the removal of the septic tanks and connection to the council sewer line? | A5: No, however you may be entitled to a balancing adjustment deduction in relation to the septic tank. | Q6: Are you entitled to claim a capital works deduction calculated in accordance with Division 43 of the ITAA 1997 in relation to the costs you incurred with the connection to the sewer line? | A6: Yes.

Relevant facts and circumstances: You and your spouse own a residential rental property. You were issued with a Notice to demolish numerous unauthorised building works. You were required to demolish the following building works on the property: ● Garage (used as granny flat) ● Patio ● Brick fencing (retaining wall). You had a building inspector attend the property to verify the building works were in fact unauthorised structures. The inspector did confirm this and advised to demolish the building works. The inspector did advise that the retaining wall could be repaired and brought back to an authorised standard. You undertook to repair the retaining wall however once work was started to repair the retaining wall it came to your attention that the wall contained asbestos. You were then required to remove the retaining wall entirely and start from new. During this time you decided to take out the septic tanks and connect to the Council main lines sewer connection. You were required to do this as the Council have instructed that all properties must now be connected to the mains line. The septic tanks have been treated as plant and equipment. You have incurred costs with the removal of the unauthorised building works: You have not claimed any capital works deductions for the garage, patio or retaining wall. You have also not claimed any depreciating expenses in relation to the septic tanks. You did not receive any salvage amounts for the removal of the capital works and the disposal of the depreciating assets contained within the property.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 25-10 | Income Tax Assessment Act 1997 Section 40-30 | Income Tax Assessment Act 1997 Section 40-40 | Income Tax Assessment Act 1997 Section 40-285 | Income Tax Assessment Act 1997 Section 43-10 | Income Tax Assessment Act 1997 Section 43-20 | Income Tax Assessment Act 1997 Section 43-25 | Income Tax Assessment Act 1997 Section 43-40 | Income Tax Assessment Act 1997 Section 43-70 | Income Tax Assessment Act 1997 Section 43-75 | Income Tax Assessment Act 1997 Section 43-140 | Income Tax Assessment Act 1997 Section 43-210 | Income Tax Assessment Act 1997 Section 43-250 | Income Tax Assessment Act 1997 Section 43-255

Reasons for decision: Summary: Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997) discusses the deductibility of capital works and details the conditions which allow you to claim a deduction. Expenditure on demolishing existing structures is not an amount that can contribute to a deduction for capital works under section 43-10 of the ITAA 1997. This is because it is not construction expenditure (paragraph 43-70(2)(b) of the ITAA 1997). However, such expenditure may be taken into account in calculating a deduction under section 43-40 of the ITAA 1997 (see below). Accordingly, as it is specifically excluded by paragraph 43-70(2)(b) of the ITAA 1997, you cannot claim a deduction for the expenses associated with demolishing the garage and patio (including the approvals and building inspection). | Detailed Reasoning - Undeducted construction expenditure: Section 43-40 of the ITAA 1997 allows a deduction if there is undeducted construction expenditure for qualifying capital works which have been “destroyed”. Both voluntary and involuntary destruction of the relevant capital works fall within the scope of this deduction rule. Further, the deduction will apply if all or a part of “your area” is destroyed. The deduction allowed under section 43-40 of the ITAA 1997 only applies if: (a) the entity has been allowed, or can claim, a deduction under Division 43 or under former Division 10C or 10D of ITAA 1936 with respect to the entity's area of the capital works; and (b) there is an amount of undeducted construction expenditure for your area; and (c) your area was being used in the way that applies under the table in section 43-140 immediately before the destruction or, if not, neither the entity nor any other entity has used the construction expenditure area for any purpose since it was last used by the relevant entity in the way that applies under the table in section 43-140. The amount deductible under section 43-40 of the ITAA 1997 is calculated using the method statement set out in section 43-250 of the ITAA 1997. Step 1 in section 43-250 provides that the balancing deduction amount is the undeducted construction expenditure for the destroyed capital works that exceeds the amounts you have received, or have a right to receive, for the destruction of the capital works. Section 43-255 of the ITAA 1997 provides that the amounts you have received or have a right to receive for the destruction of the capital works include: (a) an amount received under an insurance policy or otherwise for the destruction of the capital works, and (b) an amount received for disposing of any property salvaged from the demolition, less any demolition expenditure incurred on the property. In calculating the balancing deduction under section 43-250 of the ITAA 1997, demolition expenditure simply acts to offset the lessening of deduction that occurs because of the fact that an amount has been received for disposing of the destroyed capital works. Even if you are able to determine that there is undeducted construction expenditure, the demolition expenses cannot be used in calculating a deduction under section 43-40 of the ITAA 1997 as no amount has been received for the destruction of the capital works. For further information on capital works deductions available for rental properties, including the information you will need to determine if you are eligible for any deductions, visit our website ato.gov.au and search for ‘QC 21620’. | Detailed Reasoning - Cost base of property for CGT purposes: Even though you are unable to claim an immediate deduction for these expenses incurred with demolishing the capital works, you may be able to include them in the costs base for CGT purposes. The fourth element of the cost base allows you to include capital expenditure you incurred where the purpose or the expected effect of which is to increase or preserve the asset’s value. | Detailed Reasoning - Repairs: Section 25-10 of the ITAA 1997 generally allows a deduction for expenditure incurred on repairs to premises or plant held or used by a taxpayer for the purpose of producing assessable income. However, capital expenditure is not deductible under section 25-10 of the ITAA 1997. Taxation Ruling TR 97/23 explains the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10 of the ITAA 1997. It is acknowledged in TR 97/23 that to repair property improves to some extent the condition it was in immediately before repair. A minor and incidental degree of improvement, addition or alteration may be done to property and still be a repair. However, if the work amounts to a substantial improvement, addition or alteration, it is not a repair and is not deductible under section 25-10 of the ITAA 1997. Further TR 97/23 states that a reconstruction of the whole of property (for example, fencing or a railway) is not a deductible repair. The ruling states: " Replacement or substantial reconstruction of the entirety, as distinct from the subsidiary parts of the whole, is an improvement. " In your circumstances, the old retaining wall was required to be taken down and replaced to bring it in line with Australian standards and building codes. Once reconstruction began on the wall it was identified that the wall contained asbestos and as a result the entire retaining wall was removed and replaced. The expenditure incurred for reconstruction of the retaining wall is not a deductible repair under section 25-10 of the ITAA 1997 because the whole retaining wall was replaced, making it a reconstruction of the entirety. The costs associated with the construction of the new retaining wall are of a capital nature. | Detailed Reasoning - Removal of asbestos: Section 40-775 of the ITAA 1997 provides a deduction for expenditure for the sole and dominant purpose of carrying on environmental protection activities. An environmental protection activity is an activity carried on in preventing, fighting or remedying pollution. Pollution includes contamination by harmful or potentially dangerous substances such as asbestos. Due to the identification of asbestos in the retaining wall you were required to have this removed before commencing on the installation of the new retaining wall. You were required to carry out additional work to remedy the pollution. When an environmental activity is carried out as part of a larger renovation and you are able to quantify the cost associated with removal of the pollution a deduction is allowable under section 40-775 of the ITAA 1997. Therefore the costs incurred specifically for the removal of the asbestos are an allowable deduction under section 40-775 of the ITAA 1997. | Detailed Reasoning - Deduction for capital works: The capital works provisions allow a deduction for certain capital expenditure on the construction of buildings and other capital works which are used for the purpose of producing assessable income. Eligible construction expenditure is written off over a number of years. Division 43 of the ITAA 1997 applies to capital works being certain buildings, and also capital works that are structural improvements begun after DDMMYY. Examples of structural improvements include fences and retaining walls. Your expenditure on the new retaining wall is therefore subject to the capital works provisions. The amount you can deduct is a portion of your construction expenditure. In the case of structural improvements begun after DDMMYY the rate of deduction is 2.5%. However, not more than 100% of your construction expenditure can be deducted. This imposes a time limit on the period over which your construction expenditure can be deducted. In your case, the construction expenditure in relation to the construction of the new retaining wall may be written off over a 40 year period, at a rate of 2.5% per year. Section 43-70 ITAA 1997 defines construction expenditure as capital expenditure incurred in respect of the construction of capital works. Taxation Ruling TR 97/25 states that construction expenditure includes preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits. The expenses incurred with regards to obtaining approvals and permits for the retaining wall would be considered capital expenditure associated with replacement of the retaining wall and will also be included in the construction expenditure amount. | Detailed Reasoning - Removal of septic tanks: Expenditure incurred for repairs is not deductible under section 25-10 of the ITAA 1997 if the expenditure is of a capital nature. Taxation ruling 97/23 states that expenditure for repairs to property is capital expenditure if the expenditure, rather than being for work done to restore the property by renewal or replacement of subsidiary parts of a whole, is for work that is a renewal in the sense of a reconstruction of the entirety. The term 'entirety' is used by the courts in repair cases to refer to something 'separately identifiable as a principal item of capital equipment' ( Lindsay v FC of T (1960) 106 CLR 377 at 385; (1960) 12 ATD 197 at 201). The removal of the septic tanks is considered to be capital in nature and would not be considered to be a repair and deductible under section 25-10 of the ITAA 1997. | Detailed Reasoning - Connection to mains line: The costs associated with the connection to the mains line would be a structural improvement under section 43-20 of the ITAA 1997 of the capital works provisions. The same principles outlined above regarding the retaining wall under the capital works provisions will apply. In your case, the construction expenditure in relation to connection to the mains line may be written off over a 40 year period, at a rate of 2.5% per year. | Detailed Reasoning - Additional information: Section 40-280 of the ITAA 1997 allows for a balancing adjustment to occur when you stop holding a depreciating asset. The adjustment is generally based on the difference between the actual value of the asset when you stop holding it and its adjustable value. For further information on calculating a balancing adjustment, visit our website ato.gov.au and search for ‘QC 45987’