Private ruling: Rental property expenses
Published: August 2014
Ruling period: Year ended 30 June 2014 | Year ended 30 June 2015 | Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2013

Ruling: Q1: Are you entitled to a deduction for interest incurred on money borrowed to pay interest incurred on loans used to finance renovations to a rental property and the cost of constructing new rental properties? | A1: Yes. | Q2: Are you entitled to a deduction for interest incurred on money borrowed to pay holding expenses (such as council and water rates) during the construction period of rental properties? | A2: Yes.

Relevant facts and circumstances: You purchased an investment property. The property was rented out through a real estate agent. The real estate agent informed you of a major health and safety issues in the property and the tenants were told to move out. To resolve the issues, renovations were carried out to the property. As the property was untenanted you decided to make some structural improvements to the property at the same time. The property was rented out again after the issues were resolved. You borrowed money to finance the cost of constructing new rental properties. During the construction period you will need to pay fees such as council rates, water rates and interest on loans. You will use available funds in an existing loan to pay interest expenses on other deductible loans, and to pay holding costs during the construction period. Construction of the new dwellings has commenced and is expected to be completed within a reasonable timeframe.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1

Reasons for decision: Summary: You can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income except where the loss or outgoing is capital, private or domestic in nature or relates to the earning of exempt income (section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)). Expenditure incurred on interest and holding expenses such as council rates and water rates falls for consideration under section 8-1 of the ITAA 1997. | Detailed Reasoning - Interest incurred prior to derivation of assessable income: In Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 ( Steele ), the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. It follows from Steele that interest incurred in 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 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 • continuing efforts are undertaken in pursuit of that end. In your case, you have taken out a number of loans to finance the renovation of a rental property as well as financing the construction of new rental properties. The interest incurred on these loans is not considered preliminary or to have been incurred too soon as it is incurred on funds borrowed for the sole purpose of producing income. In addition, the funds borrowed are not to be used for any private or domestic purpose; they are being borrowed for the purpose of gaining or producing assessable income. The length of time between the commencement of construction and the availability of the dwellings for rent, in the circumstances, is not considered so long that the necessary connection between the interest outgoings and the assessable income is lost. Therefore, you are entitled to a deduction under section 8-1 of the ITAA 1997 for the interest incurred on funds borrowed to finance the renovations and construction of the new rental properties. This includes the interest you will incur on money drawn down to pay the interest incurred on the other loans that have been used to finance the renovations and construction costs. | Detailed Reasoning - Holding expenses such as council rates and water rates: While Steele deals with the issue of interest, the principles can be applied to other types of expenditure including local council rates and water rates. Applying similar reasoning to that used above to allow your deductions for interest, you are entitled to a deduction for expenditure incurred on council rates and water rates under section 8-1 of the ITAA 1997.