Private ruling: Trust deductions
Date of advice: 8 March 2018
Published: June 2018
Ruling period: Year ending 30 June 20AA | Year ending 30 June 20BB | Year ending 30 June 20CC | Year ending 30 June 20DD | Year ending 30 June 20EE
Date scheme commenced: Summer 20XX

Ruling: A12: 

Relevant facts and circumstances: The trustee of the trust acquired a residential holiday property in Summer 20XX for $Y. This purchase price was fully funded by an interest free loan from beneficiaries of the trust to the trustee. The directors of the trustee are also beneficiaries of the trust. Beneficiaries of the trust used the property as a holiday property for some years. In 20AA the property was demolished and a redevelopment commenced to build a new house with the intention that once completed it would become a rental property and be leased to one of the beneficiaries of the trust. In Summer 20AA the trustee entered into a contract with a construction company to redevelop the property. The total cost of construction was $YY. The trustee also incurred architects fees of $Z and other professional fees for engineers, permits etc. of $ZZ. A further amount of approximately $ZZZ was incurred in purchasing furniture and fittings. The cost of redevelopment was financed by a combination of the trust’s cash resources and loans taken by the trustee. Construction of the new property was completed in Summer 20DD and in the following 12 months the property was progressively decorated, furnished and landscape gardening was undertaken to prepare the property for lease. During this period beneficiaries of the trust used the property as a holiday home for approximately X days. No rent was paid by beneficiaries for this usage and otherwise the home remained vacant. A beneficiary of the trust now proposes to enter a long term lease of the property. The lease will be a standard real estate industry contract sourced from the Consumer Affairs website. This lease would be on a “permanent rental basis” (i.e. the rental will be as if occupied for 365 days of the year rather than on a casual usage basis). The quantum of the rental will be determined by an independent assessment by a private real estate agent and hence will be set at market rates. A rental bond will be lodged with the local Bond Authority. If the tenancy proceeds the trustee expects to incur normal property expenses such as – ● Rates, land tax, repairs and maintenance. ● Interest expenses on the loans taken out to partially fund the development. ● Depreciation of assets. ● Capital works deductions. The trustee also expects to earn assessable income being the rent received from the tenant. At present the aggregate value of the loans due is $XX of which $YY relates directly to the redevelopment of the property. The balance of the loans relates to the refinancing of a margin loan. Accurate records have been kept to enable a calculation of the proportion of interest on the loans that relate to the property. The construction period of the property can be assessed as being from the date of the signing of the building contract Summer 20AA until the issue of the Certificate of Practical Completion. The trustee does not intend to seek any deductions for the period between the end of the construction period and the commencement of the lease as the property was not available to rent in that period.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 25-10 | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 Division 40.755 | Income Tax Assessment Act 1997 Division 43 | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 Division 36

Reasons for decision: Summary: Under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), expenses are generally deductible if there is a sufficient connection between the expense and the gaining or producing of assessable income. This is the case provided that the expenditure is not of a capital, private or domestic nature and includes interest on a loan, rates and land taxes connected with an income producing rental property. In your case, you have taken out loans to redevelop a rental property which will be occupied by a beneficiary of the Trust. The lessor will be charged at market rate which will be independently set. This property is expected to incur rates and land tax. Accordingly, it is considered that the bank interest, the rates, land tax, insurance, and repairs and maintenance will be incurred in connection with the purchase of a rental property which is expected to produce assessable income. The expenditure is not capital in nature and as it is you (the company) who will be taking out the loan, and it is a beneficiary who will be the tenant of the property, the expenditure will not be private or domestic in nature. Section 25-10 of the ITAA 1997 is concerned with repairs and maintenance. Whilst such expenses may be generally deductible under section 8-1 of the ITAA 1997, it is section 25-10 of the ITAA 1997 that specifies the exact nature of the allowable expense. For the cost of repairs to be deductible, they must relate directly the wear and tear of the rental property, or other damage that occurs as a result of renting out the property. The replacement of an entire structure, improvements, renovations, extensions and alterations, and initial repairs are all considered to be capital in nature and so are not allowable as a deduction. Hence that part of the interest expense in relation to the builder’s contract and also the architect’s fees would not be deductible. Construction expenditure is taken to include preliminary expenses such as architects fees, engineering fees, foundation exaction expenses and the cost of building permits. Similarly the cost of clearing land and demolishing an older building is considered to be construction and hence not deductible. Division 40 of the ITAA 1997 provides a deduction for the decline in value of depreciating assets if those assets were held for a tax purpose such as producing assessable income. Division 40 of the ITAA 1997 generally allows a deduction for the cost of a depreciating asset based on its effective life. Relevantly for residential rental properties, an immediate deduction for certain non-business depreciating assets costing $300 or less or a deduction under the low-value pools provisions may be available if Division 40 applies. Some items found in a rental property are regarded as part of the setting for the rent producing activity and are not treated a separate asset in their own right and so cannot be included in any claim for a decline in value. In your case, the cost of allowable decline in the value of depreciating assets in relation to your rental property will be deductible as the assets have been held for the purposes of producing assessable income. Division 43 of the ITAA 1997 allows a deduction for certain kinds of construction expenditure (capital works deductions). An allowable deduction is dependent on the age of the building (for example, such a deduction is not available if the construction of the building started before 22 August 1979), the intended use of the building and the type of construction expenditure. You can only claim deductions for the period during the year that the property is rented or is available for rent. In your case, the cost of an allowable capital work deduction in relation to your rental property will be deductible during the year(s) that the property is rented. Under section 40.755 of the ITAA 1997, expenses incurred for environmental protection activities are generally deductible if incurred to treat, clean up, remove or store pollution that is on or from the site of your earning activity. Accordingly, the costs of asbestos removal during the demolition of the original house would be an allowable deduction. Taxation Ruling 2004/04 deals with interest expenses and notes – 8. Outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148). The ruling sets out circumstances in which interest would be deductible, namely – • the interest is not incurred ‘too soon’, is not preliminary to the income earning activities, and is not a prelude to those activities; • the interest is not private or domestic; • the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost; • the interest is incurred with one end in view, the gaining or producing of assessable income; and In your circumstances the interest incurred for payments made in connection with necessary costs incurred in construction of this rental property would be deductible. Similarly the interest incurred for payments made in connection with necessary costs incurred which relate to rates, land tax and insurance would also be deductible. Allowable losses incurred from a particular assessable source of income form part of the calculation of the total assessable income of a taxpayer. In other words, any such losses can be deducted from the total of other assessable income to come up with a final total of assessable income. Losses not totally extinguished in this way may be carried forward and offset against the income of the taxpayer in future income years. In your case, any allowable losses that arise as a result of you renting out the property can be offset against your income from other sources. Such a deduction is available in the income year in which the expense is incurred or in future years if carried forward.

Questions relating to the period after lease commencement: 1. Are you entitled to a deduction for the allowable cost of rates, land tax, insurance, repairs and maintenance incurred in relation to a rental property which will be leased to a beneficiary? | 2. Are you entitled to a deduction for the allowable cost of interest expenses incurred in relation to the proportion of the loans which relate to payments made under the builder’s contract and also for architect’s fees? | 3. Are you entitled to a deduction for the allowable cost of interest expenses incurred in relation to the proportion of the loans which relate to payments made which relate to payments of rates, land tax, insurance, repairs and maintenance incurred in relation to the property? | 4. Are you entitled to a deduction for the cost of allowable decline in the value of depreciating assets incurred in relation to the property? | 5. Are you entitled to a deduction for the cost of clearing land and demolishing the existing building? | 6. Will the Commissioner accept calculations of costs and deductions based on the property being leased on a permanent (i.e. 365 days per year) basis rather than a apportionment based on actual usage? | 7. Will the Commissioner accept allowable losses incurred to be deducted against other assessable income; with any losses not fully utilised in any tax year able to be carried forward to be offset against income in future years? | Questions relating to the construction period: 1. Will the trustee be entitled to a deduction for the cost of asbestos removal during the demolition of the original house? | 2. Will the trustee be entitled to a deduction for the allowable cost of rates and land tax incurred during the construction period? | 3. Will the trustee be entitled to a deduction for the interest expense incurred on the proportion of the loans which relate to payments made under the builder’s contract, architect’s fees and other professional fees incurred during the construction period? | 4. Will the trustee be entitled to a deduction for the interest expense incurred on the proportion of the loans which relate to payments of rates, land tax and insurance incurred in relation to the property incurred during the construction period? | 5. In the event that the trustee is entitled to such deductions, or some part of these deductions, will the Commissioner confirm that such deductions may be claimed in the tax year during which the lease of the property commences?