Private ruling: rental property expenses and insurance proceeds
Published: May 2012
Ruling period: Year ended 30 June 2012 | Year ended 30 June 2013 | Year ended 30 June 2014 | Year ended 30 June 2015
Date scheme commenced: 1 July 2011

Ruling: Q1: Are you entitled to claim a deduction for rental property expenses (eg. loan interest and council rates) despite the property not currently being rented, or available for rent? | A1: No | Q2: Are the insurance proceeds received on destruction of your rental property assessable as ordinary (rental) income? | A2: No | Q3: Are the insurance proceeds received on destruction of your rental property considered to be merely a recoupment of the original cost of the asset, thereby having no capital gains tax implications? | A3: Yes

Relevant facts and circumstances: You own a rental property. The property was destroyed. Your insurance company intended to have the house rebuilt as cheaply as possible. However, you did not see any value in this situation and instead requested that the insurance company make the payment to you, and you would rebuild a better quality house yourself. The insurance proceeds paid to you in 2011-12 financial year. The payment was an un-dissected lump sum. You are currently renovating your former partner's house and state that you are unable to start work on re-building your rental property while undertaking the renovation project. While there is currently no rental income being received, you are still incurring loan interest and council rates in relation to your rental property.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 102-20 | Income Tax Assessment Act 1997 Section 108-5

Reasons for decision: Summary: Summary You are not entitled to claim a deduction for rental property expenses as the property is not currently rented (or available for rent) and continued efforts are not being undertaken to ensure that the property returns to deriving assessable income. The insurance proceeds received for the destruction of your property is not assessable as ordinary (rental) income as the payment was made in compensation for the loss of a capital asset (the property) and not for the loss of income. The insurance proceeds received are considered a recoupment of the original cost of the asset, therefore no capital gain or loss is applicable to you until you dispose of the asset. Detailed reasoning Rental property expenses Section 8-1 of the Income Tax Assessment Act 1997 (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. You may claim a deduction for certain expenses that you incur for your rental property. However, the property must be rented, or available for rent, for the income year in which you claim a deduction. In order to claim a deduction for rental property expenses in situations where no assessable income has been derived from the property, you must be able to show that continuing efforts are being undertaken to ensure that the property returns to deriving assessable income. While this does not require constant on-site development activity, the requirement will not be satisfied if the venture becomes dormant and the holding of the asset is passive, even if there is an intention to revive the venture some time in the future. In your case, your rental property was destroyed and will need to be re-built. You have chosen to have the insurance proceeds received from the destruction of the property paid to you, rather than another builder organised by the insurance company, and intend to re-build the property yourself. However, you have not started rebuilding your property as you are currently renovating another house. You provide that you do not have the physical capability to work on both projects simultaneously. As such, we consider that you are not making a continued effort to return the property to an income producing activity and the venture has now become dormant. Therefore, the connection between the expenses incurred in relation to the property and the production of any assessable income from the property has been lost. Accordingly, you can not claim a deduction for the rental property expenses you incurred (loan interest and council rates) until such time as your property is again rented or, available for rent. Insurance proceeds Assessable as ordinary income Section 6-5 of the ITAA 1997 provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). Ordinary income has generally been held to include 3 categories, namely income from rendering personal services, income from property and income from carrying on a business. The compensation payment received was proceeds from an insurance policy. The payment was not income from rendering personal services or income from property or income from carrying on a business. In general, a compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of income, then it will be regarded as ordinary income. If the compensation is paid for the loss of a capital asset or amount, then it will be regarded as a capital receipt and not ordinary income. In your case, you received compensation for the loss of your rental property, a capital asset, and not for the loss of income. Therefore, the payment will be considered a capital receipt and not ordinary income. Accordingly, the payment is not assessable as ordinary (rental) income. As the insurance proceeds are considered a capital receipt, we must now determine whether the proceeds are assessable under the capital gains tax provisions. Assessable under capital gains tax provisions Capital gains tax (CGT) is the tax you pay on certain gains you make. You make a capital gain or capital loss as a result of a CGT event happening to an asset in which you have an ownership interest (section 102-20 of the ITAA 1997). A CGT asset is any kind of property; or a legal or equitable right that is not property (section 108-5 of the ITAA 1997). As such, your rental property would be considered a CGT asset. Taxation Ruling TR 95/35, which deals with capital gains treatment of compensation receipts, provides that in determining which is the most relevant asset, it is appropriate to adopt a look-through approach to the transaction or arrangement which generates the compensation receipt. Paragraph 6 of TR 95/35 applies directly to the present situation and explains that: 6. If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset. Subsequent expenditure to rebuild the asset may be included in the assets cost base. That is, the cost base of the asset is reduced by the compensation received and increased by the amount paid to rebuild the asset. For example, a block of land was acquired. There was a house on the land. Fire destroyed the house and insurance proceeds of $160,000 were received. Just before the fire, the cost base of the property was $200,000. The cost base of the property is reduced by the insurance proceeds ($200,000 - $160,000) to $40,000. The house is rebuilt at a cost of $170,000. The cost base of the property just after the house is rebuilt is ($40,000 + $170,000) or $210,000. In your case, you received insurance proceeds when your rental property was destroyed. Accordingly, as per the example above, you should reduce the cost base of the property by the amount of the insurance proceeds. Subsequently, no capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset and therefore, the insurance proceeds will not be assessable under the capital gains tax provisions.

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