Private ruling: Depreciation and capital works deductions
Published: April 2015
Ruling period: Income year ended 30 July 2014 | Income year ended 30 July 2015
Date scheme commenced: 1 July 2013

Ruling: Q1: Are you entitled to a deduction for capital works for eligible construction costs from the completion of construction? | A1: Yes | Q2: Are you entitled to a deduction for decline in value of depreciating assets in respect to the newly constructed property? | A2: Yes

Relevant facts and circumstances: You purchased an investment property in 20xx. You have rented the property out since acquiring it. In July 20xx, the tenants had a house fire and the property was severely damaged. You had a landlord's insurance policy and claimed for the damages incurred by the fire. As the damage was extensive the entire property was rebuilt.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 43-20 | Income Tax Assessment Act 1997 section 43-25 | Income Tax Assessment Act 1997 section 43-30 | Income Tax Assessment Act 1997 section 43-35 | Income Tax Assessment Act 1997 section 43-70 | Income Tax Assessment Act 1997 section 40-25 | Income Tax Assessment Act 1997 section 40-30

Reasons for decision: Detailed Reasoning - Capital Works: Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997) provides a deduction for capital works attributable to a construction expenditure area that is owned or leased by the taxpayer and used during the income year for the purposes of producing assessable income. Capital works includes buildings and structural improvements and also extensions, alterations or improvements to buildings and structural improvements. Subsection 43-25(1) of the ITAA 1997 provides that the rate of deduction for capital works that began after 26 February 1992 for a residential rental property is 2.5%. However, a deduction cannot be made prior to the completion of the capital works (section 43-30 of the ITAA 1997). Capital works do not include structural improvements in the form of earthworks described in subsection 43-20(4). Similarly, capital expenditure on land (on which the capital works are to be constructed), including clearing, demolition and landscaping costs and plant, is not part of construction expenditure. These are specifically excluded by paragraphs 43-70(2)(a), (b), (c), (d) and (e) of the ITAA 1997. Section 43-70 of the ITAA 1997 defines construction expenditure as capital expenditure in respect of the construction of capital works. Construction expenditure includes: • preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits; • cost of structural features that are an integral part of the income producing buildings or income producing structural improvements, such as atriums and lift wells; and • some portion of indirect costs. In your case, your rental house was rebuilt as the result of an insurance claim. There is no basis in Division 43 of the ITAA 1997 which requires you to reduce the construction expenditure of the new building by the amount of insurance proceeds. Therefore, you are entitled to claim a deduction for capital works at a rate of 2.5% of eligible construction costs of the house, apportioned for the period it was used or available for income producing purposes. | Detailed Reasoning - Decline in value: Section 40-25 of the ITAA 1997 allows you to deduct from your assessable income an amount equal to the decline in value of a depreciating asset that you held during the year. The deduction is reduced to the extent that the asset was not used during the income year for a taxable purpose (subsection 40-25(2) of the ITAA 1997). A taxable purpose includes the purpose of producing assessable income. Depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used (subsection 40-30(1) of the ITAA 1997). A deduction for the decline in value can only be claimed by a person who is the holder or owner of the asset. Since you will be the holder or owner of the depreciating assets in your rental property and the assets will be used for producing rental income, you will be entitled to claim a deduction for the decline in value of the depreciating assets. | Detailed Reasoning - General Advice - Taxation Consequence of the Destroyed Property: The following information is provided as written guidance. A taxpayer who relies on guidance will remain liable for any tax shortfall if the guidance is incorrect or misleading and they make a mistake as a result (unless a time limit imposed by the law precludes the liability). However, they will be protected against the shortfall penalty and interest on the tax shortfall provided they relied on that guidance reasonably and in good faith. | Detailed Reasoning - Insurance proceeds and depreciating assets: When you stop holding a depreciating asset, such as when it is destroyed, a balancing adjustment event occurs (section 40-295 of the ITAA 1997). The amount of the balancing adjustment is calculated by comparing the asset's termination value with its adjustable value (section 40-285 of the ITAA 1997). The termination value of a depreciating asset that is lost or destroyed is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction (item 8 in the table in subsection 40-300(2) of the ITAA 1997. The adjustable value of an asset at a particular time is the opening adjustable value for that year plus any second element costs for the year, less its decline in value for the year up to that time (paragraph 40-85(1)(c) of the ITAA 1997). The opening adjustable value of a depreciating asset for an income year is its adjustable value to you at the end of the previous income year (subsection 40-85(2) of the ITAA 1997). If the termination value of the depreciating asset is more than its adjustable value, the difference is included in your assessable income in the income year in which the balancing adjustment event occurred (paragraph 40-285(1)(b) of the ITAA 1997). If the termination value of the depreciating asset is less than its adjustable value, the difference is deductible in the income year in which the balancing adjustment event occurred (paragraph 40-285(2)(b) of the ITAA 1997). In your case you received insurance proceeds for the loss of depreciating assets. Where the amount of insurance received (termination value) for a depreciating asset that was destroyed in the fire is more than the adjustable value of that asset, the difference is included in your assessable income. Where the amount of insurance received (termination value) for a depreciating asset that was destroyed in the fire is less than the adjustable value of that asset, you can deduct the difference. Please note that if you receive an amount for 2 or more things that include a balancing adjustment event for a depreciating asset, you take into account as its termination value only that part of what you received that is reasonably attributable to the asset (section 40-310 of the ITAA 1997). | Detailed Reasoning - Insurance proceeds and capital works: The insurance proceeds you received to compensate you for the loss of capital works is not income from rendering personal services, income from property or income from carrying on a business. The payment is also a once and for all payment and therefore does not have an element of recurrence or regularity. Additionally, the insurance proceeds were received for the loss of capital works and, therefore, take on the character of those capital works. As such, the payment is capital in nature. Accordingly, the insurance proceeds you received to compensate you for the loss of capital works is not assessable income under section 6-5 of the ITAA 1997. Your assessable income also includes statutory income amounts which are not ordinary income but are included in assessable income by provisions about assessable income (section 6-10 of the ITAA 1997). Under paragraph 20-20(2)(b) of the ITAA 1997, recoupment of a loss or outgoing is only an assessable recoupment if the taxpayer can deduct an amount for the loss or outgoing for the current year, or has deducted or is able to deduct an amount for it for an earlier income year, under any provision of the ITAA 1997. The phrase 'for the loss or outgoing' in paragraph 20-20(2)(b) of the ITAA 1997 requires a connection between the deduction and the loss or outgoing for which the taxpayer had been recouped (paragraph 11 of Taxation Determination TD 2006/31). In your case, the relevant loss or outgoing which has been recouped is the destruction of the capital works. The 'loss or outgoing' referred to in paragraph 20-20(2)(b) of the ITAA 1997 is not limited to an amount expended or paid by you. As in the present case, it extends to a loss incurred as a result of the destruction of an asset. Whilst you may have been able to deduct an amount in relation to the original construction of the capital works under section 43-40 of the ITAA 1997, this is not a deduction for the loss referred to in paragraph 20-20(2)(b) of the ITAA 1997. No deduction is available for the loss of the capital works. Accordingly, as you cannot deduct an amount for the loss or outgoing for which the insurance proceeds are received as recoupment, the insurance proceeds received for the destruction of the capital works are not an assessable recoupment under section 20-20 of the ITAA 1997. As the insurance proceeds paid to cover the cost of reconstructing the capital works that were destroyed in the fire are not ordinary or statutory income they are not included in your assessable income under any provision of the ITAA 1997. | Detailed Reasoning - Balancing deduction for destroyed capital works: You can deduct an amount (called a balancing deduction), if all, or part of your capital works are destroyed in an income year, and: • you have been allowed or can claim a capital works deduction for the capital works • the capital works were used for income producing purposes before they were destroyed • there is an amount of undeducted construction expenditure for the capital works (section 43-40 of the ITAA 1997). The amount of the balancing deduction is calculated using the formula set out in section 43-250 of the ITAA 1997. Generally, the deduction is equal to the undeducted construction expenditure at the date of the destruction of the capital works less amounts you have received or have the right to receive for the destruction of the capital works, including an amount received under an insurance policy for the destruction of capital works (section 43-255 of the ITAA 1997). If the insurance amounts received for the destruction of the capital works exceeded the undeducted construction expenditure for those capital works, the amount available as a deduction under section 43-40 of the ITAA 1997 is nil. However, if the insurance amount received for the destruction of the capital works did not exceed the undeducted construction expenditure for those capital works, you are entitled to a deduction for the undeducted construction expenditure of the destroyed capital works, less the insurance amount you received for the destruction of those capital works. It should be noted that if an amount received in respect of the destruction of property relates to both capital works for which you are claiming the balancing deduction and to property the cost of which did not form part of your construction expenditure, you must apportion the amount received to the amount that is attributable to the capital works that were destroyed. The apportionment must be reasonable (section 43-260 of the ITAA 1997). | Detailed Reasoning - Insurance proceeds and capital gains tax: Section 104-20 of the ITAA 1997 provides that where a CGT asset you own is lost or destroyed CGT event C1 occurs at the time you receive compensation for the destruction. With the capital proceeds being any compensation received. If the capital proceeds exceed the cost base of the asset then you will make a capital gain. However you may be eligible for the involuntary asset rollover which has the effect of deferring any capital gain made on the C1 event. In circumstances where you receive money in respect of the loss of the capital asset you can choose the rollover only if you incur expenditure in acquiring another CGT asset that is used for the same purpose as the original asset and you must incur at least some of the expenditure within one year after the end of the income year in which the event happens. For more information see our website (https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Debt-forgiveness-and-involuntary-disposals/Involuntary-disposal-of-a-CGT-asset/).