Private ruling: Rental deductions - legal expenses and preparation of expert reports
Date of advice: 23 July 2018
Published: September 2018
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Are you entitled to a deduction for the cost of legal expenses and the preparation of associated expert reports incurred in the course of action taken to receive compensation for repairs to a building used to produce rental income? | A1: Yes | Q2: Are you entitled to a deduction for the cost of legal expenses and the preparation of associated expert reports incurred in the course of action taken to receive compensation for rectification of structural defects for a building used to produce rental income? | A2: No | Q3: To the extent to which such expenses are not deductible, do they form part of the Capital gains tax (CGT) cost base of the asset? | A3: Yes

Relevant facts and circumstances: You purchased a brand new rental property in 20XX upon the issue of its occupancy permit. The property was available for rent as at the date of settlement. In early 20XX severe cracking appeared in several walls and an engineer was engaged to investigate the cause of the problem. The engineer suggested that the slab had been under-designed for the type of soil on which the property was situated. You incurred costs in engaging lawyers to take action against the builder, and further monies were paid to building consultants to provide their expert opinions, however the action was abandoned due to the potential costs involved. These expenses were incurred in the 20XX-XX financial year. You received a quote to rectify the design faults and structural defects; however those works were not carried out. You incurred costs to bring the internal part of the property back to its original condition, and these works included various repairs to internal parts of the property.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 Section 110-25

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 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 to the earning of exempt income. In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v. FC 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. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer ( The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097). In your case severe cracking appeared in several walls of your rental property several years after you bought it, and you engaged an engineer to investigate the cause of the problem, who advised that the underlying cause of the damage was the slab being under-designed for the type of soil on which the property was situated. You engaged lawyers to take action against the builder, and further money was paid to building consultants to provide their expert opinions, however this action was abandoned due to the further costs involved. Whilst you received a quote to rectify the design faults and structural defects, those works to rectify the structural part of your rental property were never carried out. However you did incur expenses to carry out various repairs to internal parts of the rental property, which brought the internal part of the property back to its original condition. Section 25-10 of the ITAA 1997 provides deductions for expenditure (other than capital expenditure) on repairs to premises held or used for the purpose of producing assessable income. As the expenditure you incurred was in relation to repairs to your rental property, it is considered as an outgoing on revenue account. Therefore, you are entitled to a deduction for the legal fees and other related expenses paid to building consultants that are associated with the repair expenses to your rental property under section 8-1 of the ITAA 1997. | Detailed Reasoning - Questions 2 and 3: Expenditure is capital in nature where it is made with a view to bring into existence an asset or advantage that is of enduring benefit. Capital expenditure is characterised by the fact that it is usually a one-off payment and establishes, replaces or enlarges the income producing asset. Part of the legal fees and other related expenses paid to building consultants that you have incurred are associated with the quote to rectify the structural damages to your rental property, and had these structural defects been rectified it would have ‘brought into existence an asset or advantage that is of an enduring benefit’ to your property and tenants. As such the legal fees and other related expenses associated with the structural damages / defects to your rental property are an outgoing of a capital nature, and are not deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - CGT cost base: As the expenditure is a capital expense, which is not deductible, we need to consider whether the expenditure can form part of the cost base of your rental property. Section 110-25 of the ITAA 1997 provides general rules about cost base. Subsection 110-25(5) of the ITAA 1997 states that the fourth element of the cost base for CGT purposes is capital expenditure you incurred, the purpose or expected purpose of which is to increase or preserve the asset’s value. It is reasonable to expect that the legal expenses associated with the proposed rectification of structural defects to your rental property may have increased its value had they been carried out. Therefore you would be able to include the cost incurred as part of the fourth element of cost base for capital gains tax purposes under subsection 110-25(5) of the ITAA 1997.