Private ruling: Deductions - rental properties
Date of advice: 27 May 2021
Published: August 2021
Ruling period: Income year ending 30 June 20XX | Income year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: A4:  | Q1:  | A6:  | Q2:  | A7:  | Q3:  | A9:  | Q4:  | A11: 

Relevant facts and circumstances: You jointly purchased a property (the Property) located in an overseas country in 20XX.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 25-25 | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 Division 43

Reasons for decision: Summary: You, being Person A and Person B, jointly purchased an overseas property ( the Property ) with settlement occurring in 20XX. The Property had a building located on it ( Building A ) that had been converted for holiday accommodation by the former owner of the Property. Building A was a cement block shell with a small extension built at one end where a bathroom was located that had a bath, trough, toilet and hot water service. The rest of the structure had no walls, ceilings, insulation or floor coverings. A stove and sink were located against one wall. The floor was rough concrete, and the plumbing and wiring was below standard. The paint on the outside of Building A was flaking and the roof was rusted. A pair of glass sliding doors had been placed in the door opening which were single glazed and had been fitted incorrectly. At the time the Property was acquired you proposed renovating Building A into a two-bedroom holiday unit and constructing a building for the purpose of using them to earn rental income. Your long-term goal in relation to the Property was to continue to develop the Property so that it could be fully tenanted to maximise its revenue potential which would include the construction of Building B and installing four sleeping rooms with ensuites on the vacant land in front of Building A. You did not have any intention to reside in the Property, with the Property being purchased for the sole purpose of being used as a rental property. Several years after the Property was purchased you entered into a contract with Company X to construct Building B, to be largely constructed offsite and then transported to the Property where it would be positioned adjacent to Building A. The contract included all external and internal works, including the basement works that were to be undertaken at the Property. The completion of Building B was originally scheduled for the completion during the following year, however it had not been completed after several years, with you and Company X having a protracted dispute about the number of extras that they were claiming. Building A was delivered to the Property. It was planned that it would take several weeks to complete the foundations, downstairs and the deck. However, the foundations took several months to be completed. Due to disagreements over costing to variations of the original plans, the decking and downstairs was not completed at that time. You took possession of Building B and your dealings with Company X ended. Building B consists of two levels with a laundry, bathroom, and a proposed self-contained unit located on one level, and several studio apartments each consisting of sleeping area and ensuite (Studio Units) with each room opening onto a deck, and a kitchen and living area located on another level. After you took possession of Building B you hired tradespersons to complete the decking and other activities on Building B with Person A undertaking some activities and overseeing the activities being undertaken by the tradespersons. During 20XX and 20XX Person B used most of their accumulated annual leave to spend time on the Property to enable you to bring Building A up to rental standard. You made multiple trips to the overseas country in which the Property was located, both together and separately, and stayed at Building A while working on various activities on the Property. However, Person B was diagnosed with a medical condition which prevented them from returning to the Property for several months, delaying the completion of the activities of the buildings. The activities undertaken on Building A were completed in 20XX and it was made available for rent. Building A had continued to be used by you while you were working on the Property until it was rented out and has not been used by any of your associates, related entities or family members since the Property was purchased until the present time Building A was rented out as a managed apartment from around a month after it was made available for rent to several tenants paying separately, with the final tenants moving out after several months. After a short period, Building A was rented out permanently to the current tenant and had continuously been rented out since it was first available for rent, with the exception of a short period prior to the current tenant's use of Building A. Building A tenants do not have access to Building B as part of their tenancy. All connections for Building B, except for gas fitting, deck certificate and concreting, were achieved by the time Building A was first available for rent, which were completed during the following months. Work continued on the completion of Building A until Person B was diagnosed with a serious medical condition. During the following month, several of the completed Studio Units were made available for rent and have been continuously available for rent since then. One of the completed Studio Units is being used by you for storage purposes. The Studio Units were rented out shortly after they were made available for rent, with the tenants having access to their individual Studio Unit, and lounge and kitchen on one level. The tenants also have access to laundry, and storeroom, being the unfinished proposed self-contained unit, on the other level. The original tenants have continued to stay at Building B from their initial tenanting until the end of the ruling period. The construction of Building B was not completed during the period covered by this ruling. You anticipate completing the construction of Building B and renting all Studio Units out permanently when you are able to return to the overseas country. You borrowed funds through the following three bank loans to use in relation to the purchase of the Property and/or the activities on Building A and/or activities in relation to Building B: • Loan A, obtained prior to the Property being purchased • Loan B , obtained after the Property was purchased; and • Loan C , obtained after the Property was purchased. During the 20XX income year the three loans were used solely in relation to the Property and/or Building A and/or Building B. During the following income year only Loan A and Loan B were used solely for those purposes. The following expenses were incurred in relation to the Property during Year One: • bank fees • borrowing expenses • capital allowances • capital works • electricity • insurance • interest - Loan A, Loan B and Loan C • rates; and • telephone and internet. The Property's Financial Statement for Year Two includes the following expenses: • interest - Loan A and Loan B • rates • insurance • Building B expenses consisting of: - Expenses(collectively referred to as the Expenses ) : - Capital allowances(collectively referred to as the Capital Allowances ) consisting of blinds and curtains - Capital works(collectively referred to as the Capital Works Expenses) . The profitability of the Property has been impacted by COVID-19 and you consider that the future profitability will depend on the local rental market, with some small signs of recovery. You expect the Property to be profitable over the next few years, returning to profitability as the market improves. You have changed the use of the Property to permanent rental to mitigate any revenue losses while tourism is restricted by COVID-19. Due to Person B's health issues, your long term conditions have changed in relation to the Property and your current plan is to rent Buildings A and B on a permanent basis, and to subdivide the Property and sell the lot on which Building A is located on in the future to reduce your debts without materially impacting the rental income. When Person A is able to return to the Property, they will empty out the Studio Unit currently being used as a storeroom and will transfer the items stored there to the unfinished proposed self-contained studio on the ground level which will enable the Studio Unit currently being used as a storeroom to be rented. Person A will organise for an onsite caravan to stay in that will be located on the Property and the last Studio Unit will be made available for rent as soon as possible. | Detailed Reasoning - Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 Income Tax Assessment Act 1997 section 25-25 Income Tax Assessment Act 1997 Division 40 Income Tax Assessment Act 1997 Division 43 | Detailed Reasoning - Reasons for decision: Building A was made available for rent from late May 20XX and several of the Studio Units were available for rent after several months, being in the next income year. You incurred expenses in relation to the Property, Building A and/or Building B during the income years covered by this ruling and we have considered your eligibility to claim a deduction in relation to those expenses as follows: Question 1: Are you entitled to claim a deduction for your share of the interest charged in relation to Loan A incurred during the ruling period under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? Question 2: Are you entitled to claim a deduction for your share of the interest charged in relation to Loan B incurred during the ruling period under section 8-1 of the ITAA 1997? Question 3: Are you entitled to claim a deduction for your share of the interest charged in relation to Loan C incurred during Year One under section 8-1 of the ITAA 1997? Question 4: Are you entitled to claim a deduction for your share of the banking fees, electricity, telephone and internet incurred in relation to the Property during Year One under section 8-1 of the ITAA 1997? Question 5: Are you entitled to claim a deduction for your share of the rates and insurance incurred in relation to the Property during the ruling period under section 8-1 of the ITAA 1997? Question 6: Are you entitled to claim a deduction for your share of the Expenses incurred in relation to Building B during Year Two under section 8-1 of the ITAA 1997? Detailed reasoning: You purchased the Property which had Building A located on it. You used Building A to stay in while you were in undertaking the activities to get Building A into a suitable condition to be rented out during the 20XX income year until Building A was rented out late in the income year. The completion of the construction of Building B was not completed during the period covered by this ruling. While the several of the completed Studio Units and the lounge, kitchen and laundry located were rented out during the following income year after Building A had been rented out, the construction of the self-contained unit was not completed and had been used as a storage area for the tenants. You obtained three loans to fund the purchase of the Property and/or activities in relation to Building A and/or Building B which were all used solely for that purpose during the 20XX income year, being the income year in which Building A was rented out, with only two loans being used solely for any of those purposes during the following income year. Expenses were incurred in both income years in relation to the Property and/or Building A and/or Building B which we have considered below when determining whether you are eligible to claim deductions for your share of those expenses: | Detailed Reasoning - General deductions under section 8-1 of the ITAA 1997: Section 8-1 of the ITAA 1997 allows you a deduction for any loss or outgoing that is incurred in gaining or producing your assessable income, to the extent that it is not of a private, capital or domestic nature. We have considered the following expenses and your entitlement to claim deductions under section 8-1 of the ITAA 1997: | Detailed Reasoning - Interest: Interest expense is deductible under section 8-1 of the ITAA 1997 if and to the extent to which it is incurred in gaining or producing the assessable income or in carrying on a business for that purpose, except to the extent to which it is of a capital, private or domestic nature or incurred in gaining or producing exempt income. Taxation Ruling TR 95/25 Income tax deduction for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v Roberts; FC of T v Smith provides the Commissioner's view regarding the deductibility of interest expenses. There must be a sufficient connection between the interest expense and the activities which produce assessable income to claim a deduction. To determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put. The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Accordingly, it follows that if a loan is used for business or investment purposes from which income is to be derived, the interest expense incurred on the loan will be deductible. Under Taxation Ruling TR 2004/4 outlines that interest may be claimed for a period prior to rent being received if the interest was incurred during a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstances: • The interest is not preliminary to the income-earning activities; • The interest is not private or domestic; • The period of interest outgoings before the derivation of assessable income is not so long that the necessary connection between the outgoings and assessable income is lost; • The interest is incurred with one end in view: the gaining or producing of assessable income; and • Continuing efforts are undertaken in pursuit of that end. This therefore means that, provided the ATO is satisfied that the above conditions have been met, a tax deduction for interest expenses incurred can be claimed before rental income is derived where, for example, the investment property is being constructed and/or undergoing construction for income-producing purposes. It is very important that the intention must always be and continues to exist for the generation of assessable income at all times, where the nexus between the interest expense incurred and the intention of deriving assessable income (rent) must not be broken, even though at the time there is no assessable income derived. In your case, you borrowed money to purchase an investment property. Application to your situation: You obtained a bank loan prior to the purchase of the Property and following its purchase, to use to develop it and the existing Building A so that it could be used for rental purposes. Following the purchase of the Property you continued to undertake activities to get Building A in a rentable condition, with it being available for rent several years after the Property had been purchased. You also undertook activities to have Building B constructed, entering into a contract to have it constructed several years after the Property was purchased, with it being delivered to the Property and you taking possession of it at the start of the period covered under this ruling. Activities were undertaken to complete the construction of Building B so that it could be rented out with several Studio Units being rented out during the following income year, with tenants having access to their individual Studio Unit, lounge, kitchen, laundry and storeroom being the proposes self-contained unit. You incurred interest expenses in relation to the bank loans, with all loans being solely in relation to the Property and/or Building A and/or Building B in Year One, but only two bank loans were used solely for those purposes during Year Two. Based on the information provided it is viewed that you had continuously endeavoured to progress the activities on the Property with the aim to rent out Building A and Building B. While there had been some delays in the activities, the connection between the interest expenses you incurred, your proposed use of the Property was not lost in accordance with the principles contained in TR 2004/4. After reviewing the information provided with this ruling and the facts of your situation it is viewed that you are entitled to claim a deduction for your share of the interest expenses incurred in relation to the three bank loans the 20XX income year, and the interest expenses incurred in relation to the Loan A and Loan B in the following income year. | Detailed Reasoning - Banking fees, electricity, rates, insurance and the Expenses incurred in relation to Building B: You incurred the following expenses: • rates and insurance during the 20XX and 20XX income years relation to the Property • banking fees, electricity, telephone and internet were incurred in Year One; and • Several expenses collectively referred to as 'The Expenses' were incurred in relation to Building B in Year Two. You stayed in Building A during the periods you travelled to undertake activities to get Building A and/or Building B into rental condition. Therefore, there was some personal/private use of the Property during both of the income years in the ruling period. Based on the information provided with this ruling and the facts of your situation it is viewed that the expenses were incurred in relation to activities being undertaken to get the Property, being Building A and/or Building B, into a suitable condition to be used for rental purposes. Therefore, as they were incurred in relation to gaining/earning your assessable income you can claim a deduction for your share of the expenses to the extent that they are reduced by any personal/private use of the Property and/or Building A and/or Building B during the 20XX and/or 20XX income years. Question 7: Are you entitled to claim a deduction for your share of the borrowing fees incurred during Year One under section 25-25 of the ITAA 1997? Detailed reasoning: | Detailed Reasoning - Borrowing fee deductions: Expenditure incurred for borrowing money, such as establishment fees, legal fees, stamp duty) is deductible only to the extent that the money is used by the taxpayer for the purpose of producing assessable income under section 25-25 of the ITAA 1997. The amount of the deduction depends on whether the borrowed money is used solely or only partly for the purpose of producing assessable income. The expression 'purpose of producing assessable income' is defined in subsection 995-1(1) of the ITAA 1997 to include the purpose of gaining or producing assessable income and carrying on a business for the purpose of gaining or producing assessable income. In most cases, the deduction is spread over the period of the loan or five years, whichever is the shorter. However, in certain circumstances where the total borrowing expenses incurred in an income year are $100 or less, the total amount is deductible in that year. Application to your situation: As discussed above, you had obtained several loans to purchase the Property and to undertake the activities in relation to Building A and Building B for the purpose of renting them out. In the 20XX income year you had borrowing expenses, being calculated as one fifth of the total borrowing expenses. The loan/s were obtained for the purpose of earning rental income from the Property. Therefore, you are entitled to claim a deduction in relation to your share of the borrowing fees in the 20XX-XX income year to the extent that the loans were not used for any personal/private use. Question 8: Are you entitled to claim a deduction for your share of the capital allowances for the ruling period under Division 40 of the ITAA 1997? Detailed reasoning | Detailed Reasoning - Capital allowances: Section 40-25 of the ITAA 1997 allows a deduction for the decline in value (depreciation) of a depreciating asset you hold, to the extent the asset is used for a taxable purpose. Depreciating assets are those items that can be described as plant, which do not form part of the premises. These items are usually: separately identifiable; not likely to be permanent and expected to be replaced within a relatively short period and not part of the structure, such as timber flooring, carpets, curtains, appliances like a washing machine or fridge and furniture. Application to your situation A total capital allowance amount for the 20XX-XX income year was provided with the ruling. However, we have not been provided with sufficient information to determine any amount/s that was been included in that amount, or what it is made up of. To the extent that any amount/s included in the total capital allowance amount met the conditions contained in Division 40 of the ITAA 1997, you will be eligible to claim a deduction for your share of the capital allowances in the 20XX-XX income year. In the 20XX-XX income year the capital allowances related to blinds and curtains for Building B. The replacement of the blinds and curtains is considered to be of a capital nature and represents the renewal of the entirety and are functionally separate and independent. Therefore, you are entitled to claim a deduction for your share of the decline in value of the blinds and curtains in accordance with the uniform capital allowances to the extent that the expenses meet the conditions contained in Division 40 of the ITAA 1997. Question 9: Are you entitled to claim a deduction for your share of the capital works incurred in relation to Building A during Year One under Division 43 of the ITAA 1997? Question 10: Are you entitled to claim a deduction for your share of the capital works incurred in relation to Building B during Year One under Division 43 of the ITAA 1997? Question 11: Are you entitled to claim a deduction for your share of the Capital Works Expenses incurred in relation to Building B during Year Two under Division 43 of the ITAA 1997? Detailed reasoning: | Detailed Reasoning - Capital works: Division 43 of the ITAA 1997 provides a deduction for capital works. Section 43-20 describes the types of capital works to which Division 43 of the ITAA 1997 applies. These are broadly categorised under three headings in the section as follows: • buildings; • structural improvements; and • environment protection earthworks. The deduction amount depends on when the construction started and how the capital works are used under section 43-15 of the ITAA 1997. However, no amount can be claimed before the completion of construction of the capital works even if you used them, or part of them, before completion under section 43-30 of the ITAA 1997. Subsection 43-70(1) of the ITAA 1997 widely defines construction expenditureas capital expenditure incurred in respect of the construction of capital works. Construction expenditure is determined on the basis of the actual cost incurred in relation to the construction, such as: • architect's fees • engineering fees • surveying fees • costs associated with obtaining the necessary building approvals • costs necessary to comply with building approvals, such as the cost of building a temporary road on public land and restoring the area afterwards • foundation excavations, and • the cost of structural features that are an integral part of the income-producing buildings or income-producing structural improvements, such as atriums and lift wells. However, subsection 43-70(1) of the ITAA 1997 is limited by subsection 43-70(2) of the ITAA 1997 which lists exclusions from the definition of construction expenditure. Construction expenditure specifically excludes expenditure on: • acquiring land, demolishing existing structures or on landscaping; or • clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation work. Expenditure excluded from being counted as construction expenditure can broadly be divided into the following three categories: 1. expenditure for which a deduction is elsewhere available under either ITAA 1997 or ITAA 1936 2. expenditure which forms part of the cost base, indexed cost base or reduced cost base of an asset for capital gains tax purposes, and 3. expenditure which falls into neither of the above two categories, such as expenditure which is not relevant for tax purposes. Subsection 43-70(2) of the ITAA 1997 effectively ensures that if capital expenditure on property is deductible under provisions other than Division 43, then, by excluding those types of capital expenditure from construction expenditure, a capital works deduction cannot be available under Division 43 of the ITAA 1997. 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 states that construction expenditure includes preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits. Capital works includes buildings and structural improvements, and also extensions, alterations or improvements to buildings and structural improvements where a residential property is used for income producing purposes. Application to your situation: In the ruling a total capital works amount was provided for Year One. However, we have not been provided sufficient information to determine any amount/s that were included in the total capital works amount, or the nature of any amount/s. The activities undertaken on Building A to prepare it for renting were completed in the later part of the first income year of the ruling period, and it was made available for rental around that time. Therefore, the capital works in relation to Building A were completed in Year One, being the income year in which capital allowance deduction is being sought. However, the construction of Building B, being a building, was not completed during the period covered by this ruling. Therefore, based on the assumption that the amounts included in the total capital allowance amount meet the conditions contained in Division 40 of the ITAA 1997, and to the extent that they relate only to Building A, you will be eligible to claim a deduction for your share of the capital allowances in Year One. A total capital works amount was also provided for Year Two in relation to Building B, being the Capital Works Expenses. Insufficient information has been provided for us to be able to determine the nature of the amounts included in the Capital Works Expenses, or why they were incurred. During that income year several of the completed Studio Units had been rented out with the tenants having access to the kitchen, living area on the first level, and the laundry on the ground level. The other completed Studio Unit has been used for storage. However, the area of Building B intended to be a self-contained unit has not been completed at this point. Therefore, deductions for your share of the capital works undertaken in relation to Building B cannot be claimed during Year One, as its construction was not completed during that income year. However, deductions for your share of the capital works undertaken in relation to Building B in Year Two can be claimed to the extent that the expenses meet the conditions contained in Division 43 of the ITAA 1997.

Question 3: Are you entitled to claim a deduction for your share of the interest charged in relation to Loan C incurred during the first income year covered by the ruling (Year One) under section 8-1 of the ITAA 1997? | Answer: Yes, to the extent that any of the expenses do not relate to any personal/private use of the Property. | Answer: Yes, to the extent that they do not relate to any personal/private use. | Answer: Yes, to the extent that any of the expenses meet the conditions contained in Divisions 40 of the ITAA 1997. | Question 9: Are you entitled to claim a deduction for your share of the capital works incurred in relation to Building A during Year One in the ruling period under Division 43 of the ITAA 1997? | Answer: Yes, as the capital works activities in relation to Building A were completed during the income year in accordance with section 43-30 of the ITAA 1997. | Question 10: Are you entitled to claim a deduction for your share of the capital works incurred in relation to Building B during the Year One of the ruling period under Division 43 of the ITAA 1997? | Answer: No, as the construction of the building, being Building B, was not completed during the income year in accordance with section 43-30 of the ITAA 1997. | Answer: Yes, to the extent that any of the expenses meet the conditions contained in Division 43 of the ITAA 1997. | This ruling applies for the following periods: