Capital gain on rental property – accounting for capital work deductions

Last week, the ATO reminded property investors to be aware of “common tax traps” that can lead to an audit or a delay in the processing of refunds (see Daily Tax Update 2 August 2021). Such “traps” included the failure to declare capital gains from the sale of an investment property.

Perhaps, the ATO should have added that correctly calculating the capital gain on an investment property is also one of these traps – particularly when it comes to accounting for “Div 43 deductions for capital works” in relation to income producing properties (or the old “building write-off”).

The general rule is that the cost base of any CGT asset is reduced by any cost base expenditure that is deductible to the taxpayer.

Specifically, for assets acquired from 13 May 1997, s 110-45(2) of the ITAA 1997 states (as relevant):

(2) Expenditure …does not form part of the cost base to the extent that you    have deducted or can deduct it for an income year…

This begs the question of what “or can deduct it” means – especially in the context where a taxpayer has failed to claim any deduction for capital works at all? Does it mean that the taxpayer is still required to reduce the cost base of their post-May 1997 rental property by all the deduction for capital works they could have claimed, but didn’t? (And this could be a significant sum, which could greatly increase the assessable capital gain to the taxpayer!)

Thankfully, the Commissioner has stepped in to explain what is meant by this phrase ““or can deduct it” in TD 2005/47 (or at least what the Commissioner thinks it means). And the result is highly favourable to the taxpayer.

In short, the Commissioner takes the approach that where all or some of the deduction for capital works has not been claimed by the taxpayer, then if the taxpayer is within the time limits to go back and amend their assessment/s to claim these omitted deductions, then the cost base will only be reduced by these amounts that “can be deducted” by way of such amendment.

Otherwise, the cost base does not have to exclude all the deductible amounts for capital works which were not claimed. (See the Example in TD 2005/47.)

Finally, note that PS LA 2006/1 (GA) provides that a taxpayer is not required to reduce the cost base of a property for amounts that are otherwise deductible under Div 43 where the taxpayer “does not (as a question of fact) have sufficient information to determine the amount and nature of the construction expenditure for an asset, and does not seek to deduct any amount in relation to the construction expenditure under Division 43 (or any other provision)”.

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