Insurance Claim on a Pre CGT Property

Question

This issue relates to the repair of damage caused by a flood on 27/2/22 to a rental duplex that is strata titled – Unit 1 & Unit 2 – and the timing and amount of income and deductions that are related. Amounts roughly rounded for simplicity which don’t affect concepts.

The building was built by an me in 1979 and owned ever since – i.e. pre CGT. No Capital Works had been claimed until the Unit 1 bathroom was renovated in 2020 for $9,000 – WDV @ 30/6/22 was $8,500.

The units had strata title insurance that covered the building including the kitchen, bathroom, etc, and 2 separate contents insurance that basically covered the carpets and window coverings. The strata insurance also paid for loss of rent so I was effectively continuing to receive rent from the insurer for both units when not receiving rent from tenants although it was in lump sum amounts every few months.

Unit 1 tenant moved out immediately after the flood. Unit 2 tenant could not find alternative accommodation and was allowed to stay rent free whilst the unit was partially stripped (rent was received from the insurer). She started paying rent again from 20/10/22 when she moved into Unit 1 which was completed.

Both units were fully stripped (carpet, kitchen, bathroom, toilet, tiles, etc) and mould removed by the insurer’s building contractor who was paid directly by the insurer.

I have reviewed your article relating to this and also researched ATO articles, but I am still confused. The sections marked with a star below are what I think I need to do.

* Add payments for rent received form the Insurer to Rental Income in the Rental schedule in the year in which they were received.

The builder found water in the ceiling and required me to fix the roof. There were multiple problems with the roof so I decided to replace the tiled roof with a Colorbond Metal Roof & Gutters at a cost of $40,000 (roof covers both units) – paid by me and not recovered from the insurer – final payment made 30/6/22.

* Assume Capital Works deduction for roof of $40,000 @ 2.5% from 30/6/22.

UNIT 1
Unit 1 was fully restored by the insurer’s contractor and paid directly from the insurer to the contractor. Unit 1 was completed and ready for occupancy on 25/10/22 when tenant moved in.

* Capital Work (Div 43) claim for 2020 bathroom reno continues as is i.e. 2.5% of $9,000 in 2023 and continuing in future years.

* $500 building excess paid in Feb 22 and claimed as rental expense in 2022 TR.

* Can I claim capital works deduction for the builders cost to the insurer ($150,000).

Floor Coverings – I received $9,000 from the insurer on 1/9/22 for the carpet that was destroyed ($9,600 less excess of $600), and I paid $10,000 to lay Vinyl hybrid tiles instead on 5/9/22. The WDV of the old carpet was $50.

*In Depreciation Schedule, continue to depreciate the old carpet as per normal. Add $9,000 as other income to rental schedule and claim for rental repair of $10,000 in 2023 Tax Return.

*Add $8,000 as other income to rental schedule and claim for rental repair of $4,000 in 2023 Tax Return.

UNIT 2
Strata – After multiple delays and difficulties with dealing with the insurer’s building contractor, I decided to take a payout from the insurer. $115,000 was received on 31/7/23. I signed a contract with my builder dated 29/06/2023 for $120,000 with payments staggered over the period required to complete the works. Assume work is completed and the unit ready for occupancy on 30/09/23.

* Difference of $5,000 is included as capital works deduction @ 2.5% from 30/09/23 in 2024 TR. Can I claim the full amount of $115,000?

Floor Coverings – I received $8,500 from the insurer on 1/9/22 for the carpet that was destroyed ($9,100 less excess of $600), and I paid $4,000 to supply new Vinyl hybrid floor tiles instead on 06/07/2023. The laying of the new vinyl tiles was included in the building contract.
The WDV of the old carpet was $50. The replacement tiles were not actually installed until July 2023.

* In Depreciation Schedule continue to depreciate the old carpet as per normal. Add $8,500 as other income to rental schedule and claim for rental repair of $4,000 in 2023 Tax Return. Should I try and get the cost of laying from the builder and add that as a repair?

Curtains & Blinds – I received $4,500 from the insurer on 12/9/22 for the old window coverings that were destroyed, and I paid $2,000 to supply and install replacement Window Coverings (Curtains & Blinds) on 5/9/22. The WRV of the old window coverings was $0. Curtains and blinds were not actually installed until late Aug 2023.

* Add $4,500 as other income to rental schedule and claim for rental repair of $2,000 in 2024 Tax Return (or 2023 TR?).

* Confirm property maintains CGT Free status in full.

Answer

Thank you so much for allowing your question and answer to be published as it is an excellent practical application. I understand the blog is confusing, the law is confusing. Plant and equipment are treated very differently from the building. Now that I understand it was only the inside of both the buildings that were completely stripped out I have re written my response and hopefully provided a better explanation of the key points.

Key Points:

Replacements in their entirety:

It cannot be a repair if nothing of the original remains, if it is a replacement in its entirety then you are looking to depreciate.

Replace plant and equipment entirely:

When there is a plant and equipment replacement by the insurance company it is ignored (rollover) so you continue to depreciate the old piece of equipment.
When the insurance company give you a payout and you replace the equipment it is considered that the insurance company have bought the old piece of equipment off you so there is probably a balancing adjustment because the old equipment would have been written down to less than the insurance company give you. Fortunately there is a rollover in the case of accidentally destroy so instead of declaring the “profit” on the sale of the old piece of equipment to the insurance company you can roll it over in other words reducing the value of the new piece of equipment by the “profit” so you are only claiming depreciation on the difference between the old equipment’s written down value and the insurance proceeds, deducted from the price of the new equipment but it is deemed to have been acquired at the date you purchased the new equipment.

Replace Building entirely:

This is significant because the roof, walls, doors, windows etc are considered the entirety of the building. So unless the building is destroyed what the insurance company do is likely to be a repair not a replacement in its entirety. TR 97/23 does same that an insignificant area of the building could be left and it still be considered a replacement in its entirety. https://www.ato.gov.au/law/view/document?docid=TXR/TR9723/nat/ato/00001

From the ruling:

What is an ‘entirety’?

37. 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), ‘a physical thing which satisfies a particular notion’ (the Lindsay case at 106 CLR 384; 12 ATD 201) and ‘not necessarily the whole but substantially the whole of the [property] under discussion’ (the Lindsay case at 106 CLR 383-4; 12 ATD 200). There is no one correct test for what is a subsidiary part and what is an entirety. Which approach to adopt depends on the facts in each particular case and, even then, the question is one to be answered in the light of all the circumstances it is reasonable to take into account (see Regent Oil Co Ltd v. Strick Inspector of Taxes [1965] 3 All ER 174 at 179; Brown (Inspector of Taxes) v. Burnley Football and Athletic Co Ltd [1980] 3 All ER 244 at 255).

38. Property is more likely to be an entirety if:

* the property is separately identifiable as a principal item of capital equipment; or

* the thing or structure is an integral part, but only a part, of entire premises and is capable of

*providing a useful function without regard to any other part of the premises; or

* the thing or structure is a separate and distinct item of plant in itself from the thing or structure which it serves; or

* the thing or structure is a ‘unit of property’ as that expression is used in the depreciation deduction provisions of the income tax law.

39. Property is more likely to be a subsidiary part rather than an entirety if:

*it is an integral part of some larger item of plant; or

*the property is physically, commercially and functionally an inseparable part of something else.

40. Examples of property that constitute an entirety are a slipway on the business site of a slip proprietor and ship repairer (the Lindsay case); a spectators’ grandstand in a football stadium (the Burnley FC case); a bridge giving access to the driveway of a garage (Case B21 (1951) 2 TBRD 101); a substantially new race track (Case D64 72 ATC 390; (1972) 18 CTBR (NS) Case 33); and a factory drainage system comprising an underground system of concrete stormwater drains (Case G5 (1955) 7 TBRD 29). Examples of property that do not constitute an entirety are the insulation and lining for a cool room (Case T14 (1968) 18 TBRD 67) and a window in a factory (even though the window is totally restored). Something that is part of a building, e.g., a roof or wall, is just that and no more. The building itself is the entirety.

41. If a series of separate buildings collectively form and function as a single industrial undertaking or commercial complex, we take the view that each separate building in the undertaking or complex is an entirety in itself. We do not accept that the whole undertaking or complex is an entirety. As a result, the replacement of a complete building is not regarded as replacement of a subsidiary part of an entirety comprised of the undertaking or complex.

42. Work done to a part of a building, though not amounting to a replacement or reconstruction of an entirety, may still be capital expenditure and not deductible, for example, because it amounts to an improvement: see (1953) 4 CTBR (NS) Case 9 and paragraphs 44 to 57 of this Ruling for the distinction between a repair and an improvement.

So when the whole building is completely replaced in its entirety then this is a div 43 issue apart from the plant and equipment that is depreciable under Div 40 discussed above. If the whole building is replaced then you get to depreciate the new building costs over 40 years. If the whole building is not replaced ie just the roof then it is a repair so the cost is claimable as an expense.

In your case as there was no total destruction of either unit so all of the expenses are either repairs or replacements in their entirety. Plant and equipment are most likely to be replacements in their entirety but work on the building will be considered a repair because both units were still standiing . Repairs being an outright deduction and replacements in their entirety being depreciated. Further, in your case there are no CGT consequences because it is a Pre CGT asset, with no total rebuild of either of the homes so they remain pre CGT and there are no improvements over and above the threshold.

There is a table at the back of this booklet https://www.ato.gov.au/uploadedFiles/Content/IND/Downloads/Rental-properties-2022.pdf that divides most building items between Div 43 (building) and plant and equipment (Div 40) It is generally the P&E that is considered a replacement in its entirety. A repair cannot be a replacement in its entirety, there has to be something of the original left to meet the definition of repair.

Now let’s look at each of your questions one by one and apply the blog https://www.bantacs.com.au/Jblog/property-damage-from-fire/#more-419

I hope you understand that my answers are brief because the number of questions goes way beyond the single question limit for a basic askbantacs question. I am now putting my answers in purple.

* Add payments for rent received form the Insurer to Rental Income in the Rental schedule in the year in which they were received.

Yes and claim expenses relating to the rental property as accidental destruction and under 3 years before rented again.

This is not considered a replacement in its entirety because the roof is supported by the walls of the house so the building is the entirety. Accordingly, this could be considered a repair as long as the change of materials is not an improvement. TR 97/23 discusses what is an improvement and is discussed further in the next point.

* Assume Capital Works deduction for roof of $40,000 @ 2.5% from 30/6/22

This would only be the case if it was considered an improvement otherwise it is an outright tax deduction. If the walls were not replaced by the insurance company it sounds like you still have a fair amount of the entirety left so this is a repair. But for the question of whether it is an improvement going from tiles to metal. I think you have a very good case for arguing it is a repair not an improvement. I am assuming here that it would be cheaper than a tiled roof too. If it is considered an improvement then there is no deduction for a repair and the cost of the new roof is depreciated over 40 yeas at 2.5% Here are some examples from TR 97/23 the ATO ruling on when repairs are tax deductible. Deductible under 25-10 means it is a repair not an improvement.

120. An important question in distinguishing between a repair and an improvement is whether expenditure incurred in replacing or renewing a part of property with a material of a different type from the original is a repair of the property or an improvement to it.

121. The material used does not have to be exactly the same as the original material for the work to be a repair. Similarly, the use of different material, whether it happens to be cheaper or more expensive than the original material being replaced, does not necessarily rule out the work being a repair.

122. It needs to be borne in mind that repairing property to some extent improves the condition it was in immediately before repair. Whether the use of a more modern material to replace the original material qualifies as a repair is a question determined on the facts of each case.

123. What is determinative of deductibility under section 25-10, if different material is used, is whether the work done restores the efficiency of function of the property (without changing its character), not whether the same material as the original is used. We accept that use of different material may result in a minor and incidental degree of improvement in the property but still only restore the efficiency of function of the property. If the degree of improvement is more than minor and incidental, the expenditure is of a capital nature and not deductible under section 25-10.

124. Relevant considerations, consistently with the approach taken by the High Court in the W Thomas & Co case and the Western Suburbs Cinemas case, in distinguishing generally between a repair and an improvement, are:

(a) whether or not the thing replaced or renewed was a major and important part of the structure of the property (at 86 CLR 106; 9 ATD 454);

(b) whether the work performed did more than meet the need for restoration of efficiency of function (at 86 CLR 106; 9 ATD 454 and at 115 CLR 72; 14 ATD 87), bearing in mind that ‘repair’ involves a restoration of a thing to a condition it formerly had without changing its character;

(d) whether the new thing has considerable advantages over the old one, including the advantage that it reduces the likelihood of repair bills in the future (at 86 CLR 106; 9 ATD 454).

Example 8

172. Mary Fabrica owns a factory in which the bitumen floor laid on a gravel base needs repairing. She replaces it with a new floor consisting of an underlay of concrete topped with granolith (a paving stone of crushed granite and cement). The new floor, from a functional efficiency (rather than an appearance) point of view, is not superior in quality to the old floor. The new floor performs precisely the same function as the old and is no more satisfactory. In fact, the new floor is more expensive to repair than the old. Because the new floor is not a substantial improvement, it is a repair and its cost is deductible under section 25-10: Case T75 (1968) 18 TBRD 377; (1968) 14 CTBR (NS) Case 40.

Technological advances or enhancements

Example 9

173. Switched-On Pty Ltd decides, after controlling its furnace for 25 years with electro-mechanical switches and gauges, to replace them with computerised controls. The computerised controls perform the same function as the original controls. Electro-mechanical controls are no longer mass produced and, if made to order, would cost substantially more than the computerised controls. The degree of improvement in the efficiency of the furnace’s function is only minor and incidental, its character has not changed and the operation and output of the furnace have not altered. The cost of replacing the controls is deductible under section 25-10 of the ITAA 1997.

Example 10

174. Wind Tunnel Pty Ltd has a malfunctioning vibration monitor for one of its blower fans. It replaces the old monitor with a digital monitor. The new monitor gives a more accurate reading than the old one but this is superfluous to the company’s needs because it only needs to ensure that the blower operates within a certain vibration range. The facility for reading a precise vibration level is inherent in the digital technology used in the new monitor. The monitor involved no extra cost. The degree of improvement in the efficiency of the blower fan’s function is only minor and incidental and its character, as a blower fan, has not changed. Bearing in mind that the additional capacity of the monitor exceeds the taxpayer’s needs, and viewing the issue from the particular taxpayer’s proposed use of the blower fan and monitor, the monitor’s cost is deductible under section 25-10.

Example 11

175. Gurgler Pty Ltd needs to replace the impellor in a pump it has used for five years. A new impellor made from stainless steel would cost $8,000. If the original cast iron impellor is replaced with another cast iron one, it would cost about $4,000. The stainless steel impellor is chosen because it will provide improved functional efficiency for the pump. It will perform more efficiently as an impellor and will last three to four times longer than the cast iron type. The cost of the stainless steel impellor is not deductible under section 25-10 because:

(a) there is a substantial improvement in the functional efficiency of both the impellor and the pump;

(b) the impellor is a major and important structural part of the pump;

(d) the stainless steel impellor has considerable advantages over the old cast iron one, including the advantage that it reduces the likelihood of repair bills in the future.

UNIT 1

Unit 1 was fully restored by the insurer’s contractor and paid directly from the insurer to the contractor. Unit 1 was completed and ready for occupancy on 25/10/22 when tenant moved in.

Key point here is when you say fully restored you only mean the internals, the building still stood.

* Capital Work (Div 43) claim for 2020 bathroom reno continues as is i.e. 2.5% of $9,000 in 2023 and continuing in future years.

On the basis that all that has been done by the insurance company was a repair you can continue with this depreciation. I don’t know what was done to the bathroom and what it is like so cannot say for sure but it is likely that the bathroom is so much a part of the building that the entirety is the whole building.

* $500 building excess paid in Feb 22 and claimed as rental expense in 2022 TR.

Yes

* Can I claim capital works deduction for the builders cost to the insurer ($150,000).

Not if the work done amounts only to a repair of the entirety, as discussed above. The P&E replaced by the insurance company is completely ignored.

This is different from the above because you received cash so effectively the insurance company bought the old carpet off you. There could be a balancing adjustment of $9,550 but as discussed in the blog you are allowed a rollover so you do not have to recognise this technical profit on “sale” to the extent it is covered but the cost of the new floor coverings, so going forward you depreciate $50-$,9600+10,000=$450

*In Depreciation Schedule, continue to depreciate the old carpet as per normal. Add $9,000 as other income to rental schedule and claim for rental repair of $10,000 in 2023 Tax Return.

Curtains & Blinds – I received $8,000 from the insurer on 12/9/22 for the old window coverings that were destroyed, and I paid $4,000 to supply and install replacement Window Coverings on 5/9/22. The WDV was $0.

*Add $8,000 as other income to rental schedule and claim for rental repair of $4,000 in 2023 Tax Return.

No this is not a repair as such it is as disposal of P&E and acquiring new P&E so the same options ie rollover are available as is the case with the carpet but you spent $4,000 less than the pay out and there was not written down value so yes there is income of $4,000 profit on sale of P&E and nothing to depreciate going forward.

UNIT 2

Strata – After multiple delays and difficulties with dealing with the insurer’s building contractor, I decided to take a payout from the insurer. $115,000 was received on 31/7/23. I signed a contract with my builder dated 29/06/2023 for $120,000 with payments staggered over the period required to complete the works. Assume work is completed and the unit ready for occupancy on 30/09/23.

* Difference of $5,000 is included as capital works deduction @ 2.5% from 30/09/23 in 2024 TR. Can I claim the full amount of $115,000?

Now assuming as discussed above the building was still standing and your builder did not destroy and rebuild then this is a repair except of course for the plant and equipment which is replaced in its entirety. The $115,000 less P&E is income and the $120,000 less P&E is a deduction. You only need to include the portion of the insurance income in each year that offsets the repairs relating to the insurance pay out that have been incurred in that year.

Carpet and Vinyl tiles are P&E so treated differently to the building. This is treated the same as the carpet in Unit 1 even though you chose vinyl tiles (would be different if they were ceramic tiles) Ie the insurance company has purchased the old carpet off you. You can use rollover to avoid the balancing adjustment but as you spend less than the insurance proceeds you still have income as discussed re the curtains in unit 1.

No, insurance company has bought the old carpet off you, would be different if they had replaced it rather than given you the cash.

Same as curtains in unit 1 you have sold them to the insurer and while the rollover is available, as you spent less than the insurance proceeds there will still be a balancing adjustment, profit on the sale and nothing to depreciate going forward.

* Add $4,500 as other income to rental schedule and claim for rental repair of $2,000 in 2024 Tax Return (or 2023 TR?).

* Confirm property maintains CGT Free status in full.

As the units were not a complete rebuild, all you are talking about here is, at worst, an improvement to a pre 1985 asset and it will not affect its status if it is under the following improvement thresholds. Each unit is a separate title so a threshold each. So yes still all pre CGT. But it is probably really just a repair anyway not even an improvement so even less likely to impact the CGT free status.