Division 43 of the ITAA 1997 provides for a system of deducting capital expenditure incurred in the construction of buildings and other capital works used to produce assessable income.
You can deduct construction costs for the following capital works:
- buildings or extensions, alterations or improvements to a building
- begun in Australia after 21 August 1979 or
- begun outside Australia after 21 August 1990
- structural improvements or extensions, alterations or improvements to structural improvements begun after 26 February1992
- environmental protection earthworks on which the expenditure was incurred after 18 August 1992.
Deductions for construction costs must be based on actual costs incurred. If it is not possible to genuinely determine the actual costs, obtain an estimate by a quantity surveyor or other independent qualified person. The costs incurred by the SMSF to obtain this estimate are deductible as a tax-related expense, not as an expense in gaining or producing assessable income.
Different deduction rates apply (2.5% or 4%) depending on:
- the date the construction began
- the type of capital works
- the manner of use.
Who can claim?
The SMSF can claim a deduction under Division 43 for an income year only if it:
- owns, leases, or holds under quasi-ownership rights, part of a construction expenditure area of capital works (‘your area’)
- incurred the construction expenditure or is an assignee of the lessee or holder who incurred the expense (in the case where the fund is a lessee of the capital works or is a holder of a quasi-ownership right), and
- uses ‘your area’ in a deductible way (which generally means to produce assessable income).
In calculating the SMSF’s deduction identify ‘your area’ for each construction expenditure area of the capital works. Your area may comprise the whole of the construction area or part of it.
Lessee or holder of capital works
A lessee or holder can claim a deduction for an area of capital works leased or held under a quasi-ownership right.
To claim a deduction the lessee or holder must have:
- incurred the construction expenditure or been an assignee of the lessee who incurred the expenditure
- continuously leased or held the capital works area itself or leased or held the area that had been so held by previous lessees, holders or assignees since completion of construction, and
- used the area in a deductible way (which generally means to produce assessable income).
If there is a lapse in the lease, the entitlement to the deduction reverts to the building owner.
Requirement for deductibility
An SMSF can deduct an amount for capital works in an income year if:
- the capital works have a ‘construction expenditure area’
- there is a ‘pool of construction expenditure’ for that area, and
- the SMSF uses the area in the income year in a deductible way (which generally means to produce assessable income) set out in section 43-140 of the ITAA 1997.
No deduction until construction is complete
An SMSF cannot claim a deduction for any period before the completion of construction of the capital works even though the SMSF used them, or part of them, before completion. Additionally, the deduction cannot exceed the undeducted construction expenditure for your area (see section 43-30 of the ITAA 1997).
When capital works begin
Capital works are taken to have begun when the first step in the construction phase starts, for example, pouring foundations or sinking pylons for a building (see section 43-80 of the ITAA 1997).
Establishing the deduction base
The SMSF can deduct an amount for capital works if there is a construction expenditure area for the capital works.
Whether there is such an area and how it is identified depends on:
- the type of expenditure incurred (only construction expenditure as defined in section 43-70 of the ITAA 1997 is deductible under Division 43 of the ITAA 1997)
- the time the capital works commenced
- the area of the capital works to be owned, leased or held by the entity that incurred the expenditure
- for capital works begun before 1 July 1997, the area of the capital works that was to be used in a particular manner (see section 43-90 of the ITAA 1997).
Construction expenditure
Construction expenditure includes:
- preliminary expenses, such as architect’s fees, engineering fees, foundation excavation expenses, and costs of building permits
- costs of structural features that are an integral part of the income-producing building or income-producing structural improvements, for example, lift wells and atriums
- some portion of indirect costs.
For an owner-builder entitled to a deduction under Division 43 of the ITAA 1997, the value of their contributions to the works (that is, labour or expertise and any notional profit element) do not form part of construction expenditure. See Taxation Ruling TR 97/25 – Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements.
Construction expenditure does not include expenditure on:
- acquiring land
- demolishing existing structures
- clearing, levelling, filling, draining or otherwise preparing the construction site before carrying out excavation work
- landscaping
- plant
- property for which a deduction is allowable or would be allowable if the property were to be used for the purpose of producing assessable income under another specified provision of the ITAA 1936 or the ITAA 1997.
Construction expenditure area
The construction of the capital works must be complete before the construction expenditure area is determined. A separate construction expenditure area is created each time an entity undertakes the construction of capital works.
The construction expenditure area for capital works that started after 30 June 1997 is the part of the capital works on which the construction expenditure was incurred by an SMSF that, at the time it was incurred, was to be owned, leased or held (under quasi-ownership rights) by the SMSF.
For the construction expenditure area of capital works begun before 1 July 1997, the capital works must have been intended for use for a certain specified purpose at the time of completion. The type of capital works, and the intended use on completion, depends on the time when the capital works commenced. The first specified use construction time was 22 August 1979 (see the table at section 43-90 and subsection 43-75(2) of the ITAA 1997).
No deduction is available under Division 43 of the ITAA 1997 for capital works which began in Australia, on or before 21 August 1979 or outside Australia on or before 21 August 1990 (see subsection 43-20(1) of the ITAA 1997).
Pool of construction expenditure
The pool of construction expenditure is the portion of the construction expenditure incurred on capital works that is attributable to the construction expenditure area.
The portion of the pool of construction expenditure that is attributable to the area that is owned, leased or held by the SMSF is called ‘your construction expenditure’.
Deductible use
An SMSF can only claim a deduction under Division 43 of the ITAA 1997 if it uses the area ('your area') in a way described in Table 43-140 or Table 43-145 of Subdivision 43-D of the ITAA 1997.
Special rules about uses
Your area is taken to be used for a particular purpose or in a particular manner if:
- it is maintained ready for that use or that manner, is not used for another purpose or in any other manner, and its use had not been abandoned, or
- its use for a particular purpose or in a particular manner has temporarily ceased because of construction of an extension, alteration or improvement or the making of repairs or seasonal or climatic factors.
Your area is not accepted as being used to produce assessable income:
- if it is a building (other than a hotel building or apartment building)
- used, or for use, wholly or mainly for exhibition or display in connection with the sale of all or part of any building, and
- for which construction began after 17 July 1985 but before 1 July 1997 (if construction began after 30 June 1997, buildings that are used for display are eligible)
- if it is a building (other than a hotel building or apartment building), or an extension, alteration or improvement to such a building, where construction began after 19 July 1982 and before 18 July 1985 and it is used or available for use wholly or mainly for
- or in association with, residential accommodation, or
- exhibition or display in connection with the sale or lease of all or part of any building for use wholly or mainly for, or in association with, residential accommodation
- to the extent the building (other than a hotel building or apartment building) is for the use mainly for, or in association with, residential accommodation by the SMSF or an associate. For exceptions to this rule, see subsection 43-170(2) of the ITAA 1997.
Your area is taken to be used, or for use, wholly or mainly for, or in association with, residential accommodation if it is:
- property (other than a hotel building or apartment building) and is part of an individual’s home, or
- a building (other than a hotel building or apartment building)
- where construction began after 19 July 1982 and before 18 July 1985, and
- used, or for use, wholly or mainly for the purpose of operating a hotel, motel or guest house.
Thus a hotel, motel or guest house for which construction began during the specified time, and which does not qualify as a hotel building or apartment building (for example, because it has fewer than 10 bedrooms or apartments) does not qualify for a deduction under Division 43.
Special rules for hotel and apartment buildings are contained in section 43-180 of the ITAA 1997.
Calculation and rate of deduction
The SMSF’s entitlement to a deduction must be worked out having regard to the date the building is first used to produce assessable income after construction is completed. The first and last years of use may be apportioned. The entitlement to a deduction runs for either 25 or 40 years (the limitation period) depending on the rate of deduction applicable.
The legislation contains two calculation provisions:
- section 43-215 of the ITAA 1997 covers deduction for capital works which began before 27 February 1992
- section 43-210 of the ITAA 1997 covers deduction for capital works which began after 26 February 1992.
Capital works begun before 27 February 1992 and used as described in table 43-140 of the Income Tax Assessment Act 1997
Calculate the deduction separately for each part of capital works that meets the description of your area.
Multiply your construction expenditure by:
- the applicable rate (either 4% if the capital works began after 21 August 1984 and before 16 September 1987 or 2.5% in any other case)
and
- the number of days in the income year in which the SMSF owned, leased or held your area and used it in a relevant way.
Divide that amount by the number of days in the income year (see section 43-215 of Subdivision 43-F of the ITAA 1997).
Apportion the amount if your area is used only partly to produce assessable income.
The amount the SMSF claims cannot exceed the undeducted construction expenditure.
Capital works begun after 26 February 1992
Calculate the deduction separately for each part of the capital works that meets the description of your area.
Multiply your construction expenditure by the:
- applicable rate, and
- number of days in the income year in which the SMSF owned, leased or held your area and used it in a relevant way.
Divide that amount by the number of days in the income year (see section 43-210 of Subdivision 43-F of the ITAA 1997).
Apportion the amount if your area is used only partly to produce assessable income (or if relevant partly for the purposes of conducting research and development activities).
There is a basic entitlement to a rate of 2.5% for parts used as described in Table 43-140 (current year use). The rate is 4% for parts used as described in Table 43-145 (use in the 4% manner). See section 43-25 of the ITAA 1997.
Undeducted construction expenditure
The undeducted construction expenditure for your area is the part of your construction expenditure that remains to write off. It is used to work out:
- the number of years in which the SMSF can deduct amounts for construction expenditure, and
- the amount that the SMSF can deduct under section 43-40 of the ITAA 1997 if your area or a part of it is destroyed.
The methods for calculating undeducted construction expenditure are included in sections 43-230, 43-235 and 43-240 of the ITAA 1997.
Balancing deduction on destruction
If a building is destroyed in the circumstances described in section 43-40 of the ITAA 1997 during an income year, you can claim a deduction for the remaining amount of undeducted construction expenditure that has not yet been deducted, less any compensation received. This applies even if the destruction or demolition is voluntary.
You can claim the deduction in the income year in which the destruction occurs.
The deduction is reduced if the capital works are used in an income year only partly for the purpose of producing assessable income.
The method statement for calculating the amount of the balancing deduction is included at section 43-250 of the ITAA 1997.
For guidance, see Taxation Ruling TR 97/25 Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements and its addendum TR 97/25A.