Private ruling: Income tax deductions investment related expenses
Date of advice: 21 May 2024
Published: 1 July 2024
Ruling period: 1 July 20yy to 30 June 20yy | 1 July 20yy to 30 June 20yy | 1 July 20yy to 30 June 20yy | 1 July 20yy to 30 June 20yy | 1 July 20yyto 30 June 20yy
Date scheme commenced: 1 July 20yy

Ruling: Q1: As a result of the Proposed Steps (as defined below), will 50% of any future interest expense incurred on the original loans for the purchase of the investment property be deductible under section 8-1 of the Income Tax Assessment Act 1997 ('ITAA 1997') for the spouse A? | A1: Yes. | Q2: As a result of the Proposed Steps, will 50% of any future interest expense incurred on the original loans for the purchase of the investment property be deductible under section 8-1 of the ITAA 1997 for the Spouse B? | A2: Yes. | Q3: As a result of the Proposed Steps, will 50% of any remaining borrowing cost expenditure incurred on the original loans for the purchase of the investment property be deductible under section 25-25 of the ITAA 1997 for the spouse A? | A3: Yes. | Q4: As a result of the Proposed Steps, will 50% of any remaining borrowing cost expenditure incurred on the original loans for the purchase of the investment property be deductible under section 25-25 of the ITAA 1997 for the spouse B? | A4: Yes. | Q5: As a result of the Proposed Steps, will the spouse A be entitled to claim deductions under section 40-25 of the ITAA 1997 in relation to 50% of the new depreciating assets? | A5: Yes. | Q6: As a result of the Proposed Steps, will the spouse B be entitled to claim deductions under section 40-25 of the ITAA 1997 in relation to 50% of the new depreciating assets? | A6: No. | Q7: Will the transfer of 50% of the investment property from the spouse A to spouse B constitute a capital gains tax (CGT) event resulting in a capital gain or loss to the spouse a? | A7: Yes. | Q8: Will the capital gain or loss for the spouse A be calculated based on 50% of the market value less 50% of the cost base for the investment property? | A8: Yes. | Q9: Will the Proposed Subdivision of the two strata titles into one strata title constitute a CGT event? | A9: No.

Relevant facts and circumstances: The taxpayers are married. Around 19XX, a building comprising two two-storey semi-detached houses were erected. The houses were known as No A and No B. In the 19YY's, whilst No A and No B was still owned by one owner, the building was modified to divide each semi-detached house into two apartments, one on the ground floor and one on the first floor. The apartments were designated units 1/A, 2/A, 1/B and 2/B. The apartments were all identical size and floorplan. In July 19XX, the title of the building was converted to strata title comprising four lots (one per apartment) plus common property. The four apartments were then sold to independent third-party owners. Around 20XX, four garages were constructed under the front of the building and each lot was granted exclusive use of one garage. The construction of the garages also created two outdoor terraces above the garages, one in front of each ground floor unit. Each ground floor unit was granted exclusive use of the respective adjacent terrace. To counterbalance the benefit of the terraces, each of the top units was granted exclusive use of the roof space above the respective unit. Over the years, one owner has acquired units 1/A and 2/A (the house formerly known as No A) and the taxpayers have acquired units 1/B and 2/B (formerly No B). As such there are now only two owners in the strata plan and each effectively owns one of the original two-story semi-detached houses. On each side, the top and bottom units are joined by interconnecting doorways. Unit 2/B was purchased in 20XX and is owned 100% by the spouse B. Since acquisition, it has been the principal residence of the taxpayers. Unit 1/B was purchased in August 20YY as an investment property and is owned 100% by the spouse A. Loans in the joint names of the taxpayers were taken out to fund 100% of the purchase price and improvements (new depreciating assets) to 1/B. The loans are secured over both 1/B and 2/B. 1/B is negatively geared. Proposed Steps The taxpayers first propose to transfer to each other half of the respective units they hold (Proposed Transfer). They then propose to change the titles of the units held from two strata titles to the one strata title (Proposed Subdivison). Proposed Transfer Before the Proposed Subdivision occurs, the taxpayers propose to transfer half of each unit to each other, so that the registered owner of both 1/B and 2/B are the same. The proposed transaction is as follows: a. The spouse A will transfer 50% of 1/B to the spouse B, and b. The spouse B will transfer 50% of 2/B to the spouse A. Once that occurs, unit 2/B will continue to be the taxpayers' principal place of resident and they will jointly own the unit 1/B investment property. The existing loans which funded the purchase and improvement of 1/B will continue. No new borrowing is anticipated for the 50% purchase of 1/B. A valuation will be obtained for the investment property only. No agreements or contracts will be prepared in relation to the transfer. Proposed Subdivision To end the interdependence between the two owners, remove unnecessary strata administration and resolve the complex exclusive access arrangements in relation to the garages, terraces and roof space, the two property owners proposed to terminate the strata plan and subdivide into two freehold lots known as No A and No B i.e. return the building to its original two separate residences. No A would be owned by the other owner and No B would be owned by the taxpayers jointly. However, due to minimum lot size restrictions, the taxpayers were unable to convert No B into a freehold property. Instead, the proposal will now be to aggregate their two strata lots into one strata lot. The title change does not require any physical changes to the property, simply a change of title from their two strata titles to one strata title. The taxpayers intend, at some stage, to expand their main residence into 1/B and reside in the entire semi-detached house at No B. But for the foreseeable future, they will continue to rent out the lower half of the property currently known as unit 1/B.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 25-25 | Income Tax Assessment Act 1997 section 40-25 | Income Tax Assessment Act 1997 section 40-27 | Income Tax Assessment Act 1997 section 104-10 | Income Tax Assessment Act 1997 section 116-20 | Income Tax Assessment Act 1997 section 112-25

Reasons for decision: Summary: Yes, the spouse A can deduct 50% of the interest expenses incurred in relation to the original loans for the purchase of 1/B. | Detailed Reasoning - Detailed reasoning: Section 8-1 of ITAA 1997 allows a deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature. Taxation Ruling 1995/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith (TR 95/25) provides the Commissioner's view on the deductibility of interest expenses following the Full Federal Court decision in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith). Paragraph 3 of TR 95/25 sets out the general principles relevant to the question of whether interest is deductible under section 8-1 of the ITAA 1997: • There must be a sufficient connection between the interest expense and the activities which produce assessable income. The test is one of characterisation, and the essential character of the expenses is a question of fact to be determined by reference to all the circumstances. • The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower (the use test). • Regard must also be had to all the circumstances, including the objective purpose of the borrowing and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant (the 'purpose' test). A rigid tracing of the use or application of the borrowed money will not always be necessary or appropriate (TR 95/25 paragraph 3) and will not necessarily be determinative (TR 95/25, paragraph 27). Taxation Ruling 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities at paragraph 6 states: The deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steele)). Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. However, where a loan relates to private purposes, no deduction is allowed. | Detailed Reasoning - Application to this circumstance: As the loans were taken out to fund the purchase and improvements of 1/B, the investment property that derives rental income, the spouse A will be entitled to a deduction of the interest. After the Proposed Steps, the spouse A will continue to have 50% interest in the investment property that derives rental income. As the nexus between incurring the interest expense on the loans and gaining assessable rental income on the investment property remains for their 50% interest in the investment property, 50% of the interest expenses on the loans will be deductible to the spouse A under section 8-1 of the ITAA 1997. The conversion of the strata titles from two titles to one does not change the deductibility of the interest. | Detailed Reasoning - Question 2: As a result of the Proposed Steps, will 50% of any future interest expense incurred on the original loans for the purchase of the investment property be deductible under section 8-1 of the ITAA 1997 for the spouse B? | Summary: Yes, 50% of the future interest expenses incurred in relation to the original loans for the purchase of 1/32 will be deductible to the spouse B. | Detailed Reasoning - Detailed reasoning: As discussed above, to determine the deductibility of the interest, the purpose of the borrowing and use of the funds should be considered. | Detailed Reasoning - Application in the circumstances: The purpose of the borrowing was to fund the purchase of the investment property and the improvements. The spouse B was and still is a joint account holder on the loans. The Commissioner in Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners (TR 93/32) at paragraph 6 indicates the income/loss from a rental property must be shared according to the legal interest of the owners, except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title. The interest expense on the original loans taken out to fund the purchase of unit 1/32 will be deductible by the spouse B under section 8-1 of the ITAA 1997 to the extent of their ownership of 50%. The conversion of the strata titles from two titles to one does not change the deductibility of the interest. | Detailed Reasoning - Question 3: As a result of the Proposed Steps, will 50% of any remaining borrowing cost expenditure incurred on the original loans for the purchase of the investment property be deductible under section 25-25 of the ITAA 1997 for the spouse A? | Summary: Yes, 50% of the remaining borrowing costs on the loan will be deductible over the remaining loan period in accordance with subsection 25-25 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 25-25 of the ITAA 1997, expenditure incurred in relation to borrowing costs are deductible only to the extent that the borrowed money is used by the taxpayer for the purpose of producing assessable income. Where the borrowed money is used only partly for the purposes of producing assessable income, subsection 25-25(3) allows only a partial deduction of borrowing costs to the extent the borrowed money is used for that purpose. | Detailed Reasoning - Application in the circumstances: As 100% of the borrowed funds were used by the spouse A to purchase the investment property, and the spouse A no longer owns 50% of the property, the borrowed money is no longer solely used for the purposes of producing their assessable income. As a result, only 50% of the remaining borrowing costs will be deductible over the remaining loan period to the extent the investment property is used for the purpose of producing assessable income. The conversion of the strata titles from two titles to one does not change the deductibility of the borrowing costs. | Detailed Reasoning - Question 4: As a result of the Proposed Steps, will 50% of any remaining borrowing cost expenditure incurred on the original loans for the purchase of the investment property be deductible under section 25-25 of the ITAA 1997 for the spouse B? | Summary: Yes, the remaining borrowing costs on the loan will be deductible under section 25-25 of the ITAA 1997. The borrowing costs relate to funds used to purchase the income deriving investment property. The spouse B will own 50% of the investment property and be entitled to 50% of the remaining borrowing costs where the investment property continues to be used for the purpose of producing assessable income. | Detailed Reasoning - Application in the circumstances: As the borrowed funds were used to purchase the investment property that derives assessable income, and the spouse B after the transfer will own 50% of the property, 50% of the remaining borrowing costs will be deductible to the spouse B under section 25-25 of the ITAA 1997. The conversion of the strata titles from two titles to one does not change the deductibility of the borrowing costs. | Detailed Reasoning - Question 5: As a result of the Proposed Steps, will the spouse A be entitled to claim deductions under section 40-25 of the ITAA 1997 in relation to 50% of the new depreciating assets? | Summary: Yes. The spouse A continues to hold 50% of the new depreciation assets and will be eligible to claim 50% of the decline in value of the depreciating assets used for a taxable purpose. | Detailed Reasoning - Detailed reasoning: A deduction is available for the decline in value of a depreciating asset that is held by you to produce assessable income under section 40-25 of the ITAA. Section 40-27 of the ITAA 1997 can limit deductions for decline in value in certain second-hand depreciating assets in relation to residential rental property. Section 40-27 denies a deduction unless the holder held the asset when it was first used or first installed ready for use, such that a taxpayer cannot claim a deduction for a decline in value of certain second-hand depreciating assets against residential rental property income, unless they are using the property in carrying on a business (including the business of letting out rental properties) or they are an excluded entity. | Detailed Reasoning - Application in the circumstances: As the spouse A held the new depreciating assets when they were first used in the residential property and continues to hold 50% of the new depreciating assets, they will be eligible to claim 50% of the decline in value of the depreciating assets where they continue to be used for a taxable purpose. The conversion of the strata titles from two titles to one does not change the deductibility of the new depreciating assets. | Detailed Reasoning - Question 6: As a result of the Proposed Steps, will the spouse B be entitled to claim deductions under section 40-25 of the ITAA 1997 in relation to 50% of the new depreciating assets? | Summary: No. As the spouse B did not hold the new depreciating assets when they were first used, or installed ready for use, section 40-27 of the ITAA 1997 will disallow any deductions. | Detailed Reasoning - Application in the circumstances: The new depreciating assets were first used or installed ready for use whilst the spouse A held 100% of the assets. On transfer of 50% of the property to the spouse B, they will hold 50% of the new assets. As the spouse B did not hold the new depreciating assets when they were first used, or installed ready for use, section 40-27 of the ITAA 1997 will disallow any deduction. The conversion of the strata titles from two titles to one does not change the conclusion that the spouse B would be unable to deduct the depreciation for the new assets. | Detailed Reasoning - Question 7: Will the transfer of 50% of the investment property from the spouse A to spouse B constitute a CGT event resulting in a capital gain or loss to the spouse A? | Summary: Yes, CGT Event A1 occurs on the transfer of 50% of the investment property from the spouse A to spouse B, resulting in a capital gain or loss to the spouse A. | Detailed Reasoning - Detailed reasoning: Section 104-10 of the ITAA 1997 provides that CGT event A1 occurs when you dispose of a CGT asset, such as when there is a change of ownership. | Detailed Reasoning - Application in the circumstances: As 50% of the ownership in the investment property is transferred from spouse A to spouse B, CGT Event A1 occurs, resulting in a capital gain or loss to the spouse A. | Detailed Reasoning - Question 8: Will the capital gain or loss for the spouse A be calculated based on 50% of the market value less 50% of the cost base for the investment property? | Summary: Yes, as the transfer from spouse A to spouse B occurs with no consideration, section 116-30 of the ITAA 1997 operates to deems the capital proceeds of CGT event A1 to be market value. | Detailed Reasoning - Detailed reasoning: Subsection 104-10(4) of the ITAA 1997 provides that for CGT Event A1, you make a capital gain if the capital proceeds from the disposal are more than the asset's cost base and you make a capital loss if those capital proceeds are less than the asset's reduced cost base. Section 116-20 of the ITAA 1997 provides that the capital proceeds from a CGT event are the total of the money you have received or are entitled to receive and the market value of any other property you have received or are entitled to receive. Where on the disposal of an asset no money or property is received, the market value substitution rule contained in section 116-30 of the ITAA 1997 can apply such that you are taken to have received the market value of your ownership interest in the property at the time the CGT event occurs. | Detailed Reasoning - Application in the circumstances: As the spouse A will transfer 50% of the investment property to the spouse B for no consideration, the market value substitution rule will apply to deem the capital proceeds to be market value of 50% of the investment property at the time of the CGT event. The capital gain/loss will be calculated under section 104-10(4) of the ITAA 1997 as the difference between 50% of the market value of the property at the time of the CGT event and 50% of the cost base/reduced cost base of the investment property. | Detailed Reasoning - Question 9: Will the Proposed Subdivision of the two strata titles into one strata title constitute a CGT event? | Summary: No, subsection 112-25(4) of the ITAA 1997 outlines that the merger of the two original assets to a single new asset will not constitute a CGT event. The conversion from two strata titles to one strata title does not trigger a CGT event because it constitutes a merger for the purpose of subsection 112-25(4) of the Income Tax Assessment Act 1997. | Detailed Reasoning - Detailed reasoning: Subsection 112-25(4) of the Income Tax Assessment Act 1997 provides: If 2 or more * CGT assets (the original assets) are merged into a single asset (the new asset) and you are the beneficial owner of the original assets and the new asset: (a) the merger is not a • CGT event; and (b) each element of the • cost base and * reduced cost base of the new asset (at the time of the merging) is the sum of the corresponding elements of each original asset. | Detailed Reasoning - Application in the circumstances: Units 1 and 2 are both separate CGT assets. The two units are two different floors of the same two-story semi-detached house. The change from two strata titles at 1/B and 2/B and subsequent issue of one strata title for the entirety of the house will result in the house being a single CGT asset. The single CGT asset has been created through the merger of two separate CGT assets. The spouse A and spouse B will be equal owners in 1/B and 2/B and will be equal owners of the strata title of the house at No B. Therefore, the requirements of subsection 112-25(4) of the ITAA 1997 are met and there will be no CGT event. Each element of the single asset's cost base and reduced cost base will be the sum of the corresponding elements of the original two units.

Question 1: As a result of the Proposed Steps, will 50% of any future interest expense incurred on the original loans for the purchase of the investment property be deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the Spouse A?