Initial Repairs to Real Estate

The Australian Taxation Office ("ATO") has recently issued a draft taxation determination, TD 2001/D11, which deals with the requirements for expenditures to fall within the cost base of an asset for capital gains tax ("CGT") purposes.

Generally, CGT is calculated on the difference between the capital proceeds from the sale of an asset (or from other CGT Events) and the cost base of the asset. To be included as part of the cost base of an asset, the expenditure must fall within one of five elements. The most common element is the first element:- consideration on acquisition of the asset.

Element 4 states that in order for an expenditure to fall within this element it must be capital; incurred by the taxpayer to increase the asset’s value; and reflected in the nature or state of the asset at the time of the CGT event (ie, the disposal of the asset).

The draft determination appears to take a very strict view on the requirements for the fourth element and does not consider the position of investors making initial repairs. Investors required to make initial repairs to real estate may be put in a very difficult and unfortunate position.

Taxation law has always distinguished between what is considered to be a revenue expense and what is considered to be a capital expense when dealing with tax deductions. In respect of initial repairs to income producing properties, it is well established by the Courts that costs of initial repair at the time of acquisition are treated as capital expenditure and are not revenue expenses for the purposes of deductions. However, the fact that initial repairs are considered capital expenditure does not automatically mean that the expenses are included in the cost base for CGT purposes. To be included in the cost base of the property for the purposes of calculating CGT in the event of disposal of the property, the only possible way is for the expenditure to fall within Element 4. However, if the investor holds the income producing property for a number of years and at the time of the disposal the initial repair has been subject to wear and tear and is not reflected in the nature of the property at that time or has not increased the value of the property, on the strict view given by the draft determination, the expenditure on the initial repairs are unlikely to form part of the cost base.