Let's make sure we have the scenario and question clear first. The scenario is that you've paid a deposit to a company on some land, and they'll build you a house as part of that deal. The company goes bust and you won't get your deposit back. (Yes, it happens. All investment has a certain amount of risk.)
The question is, can you write off this deposit as a bad debt? The short answer is no.
Why is this? When you buy in such a scenario, you have bought on what is called "capital account". That means that you are not buying and selling houses and making money on the profits, which is called buying on "revenue account." Rather, you have spent money to acquire or improve a long-term asset such as equipment or buildings. When you sell the asset, at present there will be no tax on the capital gain. Likewise, if you make a loss when you sell, you can't claim that loss. And in a similar way, if your calculated risk ends up in losing your deposit, that too is not claimable.
Q: Is the deposit really a deposit?
In other words, could you argue that the deposit is not a deposit? Rather, that it is payment for a set of services including designs, council fees, etc, meaning that this is not an asset?
A: No. This doesn't really change things. However it may depend on what your contract states. If your contract indicates that the monies given to the builder are a loan to be repaid (irrespective of their nature) then it would possibly fall under the definition of a bad debt. It would be best to check the wording of your contract with your lawyer. If it reveals that this is the case, then the possibility of claiming this can be examined. However, we stress that this is very very low.
Q: The house is not an asset at this stage, so shouldn't the deposit be able to be recorded in the Profit & Loss as an expense?
A: No. Again one comes back to the purpose. The house was, in this scenario, part of a capital account purchase, not a revenue account purchase. Therefore, the lost deposit is not deductible.
Q: Any company that I have worked for where the supplier has gone under has been able to capture the loss associated in the Profit & Loss. What's the difference here?
A: No. The sort of situation where a supplier has gone under is a revenue situation. That is, supplies are bought to on-sell. A supplier is paid for goods that it doesn't deliver. Therefore, the undelivered goods for on-sale can be treated as a bad debt, provided that matters are handled correctly.
Q: I thought that a debt can be written off as "bad" when a reasonably prudent commercial person would conclude that there is no reasonable likelihood that the debt will be paid. Isn't that what the law says?
A: Yes (see here), but again that is not the situation here. That only applies in a "revenue" scenario, and only where the other requirements are met.
Q: What about legal expenses? Are they deductible?
A: Yes and No. If the legal action is taken to recover items such as interest reimbursements not paid (which would have been declared as income, i.e. as revenue) then the legal expenses are fully deductible if they come to less than $10,000 in one financial year. If more than $10,000 they are capitalised and depreciated.
However, where legal action is taken to recover deposits not paid on land/buildings ie items of a capital nature and this cost exceeds $10,000 in the financial year, then the portion of legal costs related to this would not be deductible.
The converse is also true: even if your legal costs are a mix of costs related to capital items and revenue items, the entire amount can be claimed so long as it doesn't exceed $10,000 in one financial year.
Q: So does that mean that nothing is deductible then?
A: No. The usual expenses (see here for a sample list) are still deductible.
We trust this is useful. If you have further questions, please consult your lawyer or tax professional.
Accounting for your rental residential investment property; general taxation advice.