Money assessed to be income is assessable for taxation purposes, but capital is not assessed unless it is caught under capital gains tax rules.

It is thus very important to be able to differentiate between income and capital, these have very different meanings as far as tax assessment is concerned.

It usually isn't hard to differentiate between income and capital receipts. For example rent, interest, dividends, salaries, wages, business profits and other receipts are easily classified as income.

Money coming from the sale of an asset is usually classed as capital. You do not usually pay tax on capital receipts as such, though many sales generate a capital gains event and thus any difference between the purchase and sale prices may be taken into account in the assessment of a gain or loss.

It is easy enough to understand most capital payments, obviously if you buy an investment asset for $1,000 and later sell it you won't be taxed on getting your own money back and thus the $1,000 won't be assessable as income. If you sold it for more than $1,000 there may be capital gains tax on the gain itself, but nothing on the $1,000.

Less obvious are matters of compensation and insurance. If you are paid $10,000 compensation for the loss of a limb is that income or capital? That depends on the breakdown of the payment. If the entire $10,000 was compensation for the limb it would be capital, if $5,000 was for the limb and $5,000 for replacement of wages lost while recovering from the injury then $5,000 would be capital and $5,000 would be income. In the case where such a payment is considered at least partially a payment of income there may be tax payable on this amount.

Capital gains rules are a little more complex, and for other insurance payouts a payment for an asset could conceivably be a capital gains event. The purpose of the payment makes a difference not only to how the benefit will be taxed, but in the case of insurance it may also may a difference to whether or not you were able to claim a full or partial tax deduction for the insurance premiums.

A life, trauma or total and permanent disability insurance payout is not normally assessed as income, if the policy was bought for personal use. It gets a little more complex when the policy has been bought to cover the life of a business partner, in which case some of the money may be called capital if it is to be used to fund the purchase of his share of the business, to find a replacement or other similar reasons. The money might be assessable as income if the policy was bought to also cover loss of income as a result of the business partner's death, in which case this money may be determined to be taxable income. As a rule of thumb the proportion of a benefit that is intended to be to replace lost income is usually a tax deductible premium, which is why income protection policies are always fully tax deductible.

You generally can not claim a tax deduction for payments made in the course of your business for a capital purchase. For example you can't claim a $10,000 tax deduction just because you bought $10,000 worth of shares. Understanding capital vs income is crucial for real estate investors as well, where expenses in running a property may be deemed to be capital expenses.

The rule of thumb to use in property investment is that when a repair or renovation leaves the building in better than new condition it is a capital expense and therefore can only be claimed back at sale time by increasing the cost base of the building, where the repair only restores the building to regular working order it is usually an income expense and therefore can be claimed as an immediate tax deduction. For example if you need to repair a fence because the wood pales are falling out it would usually be a deductible income expense if you just replace the lost pales and paint the fence.

You should note that "new" in this context means "in the state you bought it". If you bought the house and the fence was falling apart and immediately went about fixing it this would probably be called a capital expense by the tax office. Most renovations and repairs are thus capital expenses when you move into a house, but later on fixing up items that have deteriorated during the time you owned the place and getting them back to the state they were in when you first purchased the building.

Ripping up the fence and replacing it with a snazzy looking colourbond fence is a capital expense and not an income cost, so if you put in a better fence than original you will be making a capital purchase. You may be able to claim depreciation on any capital items and the cost of the upgrade will be added to your cost base thus reducing capital gains tax if you sell some day.

Assessable income

Ordinary income comes in many forms, but the main ones are:

• wages, salaries, fees, commissions, allowances or other payments for services rendered

• remuneration to company directors

• business income

• dividends, interest and rentals

• royalties (which can also be statutory income)

• capital gains

• eligible termination payments

Statutory income is something different, these amounts are not ordinary income but are also included in your assessable income by provisions relating to assessable income.

Statutory income includes:

• return to work payments

• accrued leave transfer payments

• bounties and subsidies received in relation to carrying out a business venture

• royalties

• an amount received for a lease obligation to make repairs to the premises

• insurance or indemnity for loss of assessable income and interest on overpayments

• interest on early payments of tax

If an amount of income is made assessable under more than one rule it is still only counted in assessable income once.