Edited version of private ruling

Authorisation Number: 1011504187696

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Ruling

Subject: rental property expenses

Are you entitled to a deduction for interest on a loan to purchase a block of land with the intention to build a rental property?

No.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2008

Relevant facts and circumstances

You are a property investor.

You bought land for investment then built a dwelling and rented out the property (Property A).

You also bought more and built a dwelling land rented out the property (Property B).

Both are still in your portfolio with successful investment outcomes.

You purchased a third block of land (Property C).

Due to the economic down turn you were unable to build on this land.

This land was intended to have a rental property built on it.

You dealt with a mortgage broker in relation to obtaining finance.

A time line of financial dealings is:

· the broker assisted with arranging finance, interest only payments through Bank A. This loan was a release of equity in property B for the purpose of future investment opportunities.

· the Bank A loan was settled

· broker assisted with arranging finance to buy Property C, interest only payments, through Bank B

· the Bank B loan was settled.

Subsequent to the settlement of the land in relation to obtaining finance to construct a dwelling on Property C, with the agreed outcome being that you needed to wait for some growth in property values in order to have sufficient equity to borrow further funds to construct.

Bank B withdrew from the home loan market and stopped accepting applications. Around the same time, the global financial crisis hit, and the property market boom came to an end. You saw a significant tightening in lending policy by many banks, in particular with NoDoc and LowDoc policies. This has resulted in you not having the ability to borrow further funds to the level required to construct on Property C, and this remains the case today.

You entered into an Agreement.

You received a quote to build a dwelling on Property C fro Builder A.

You received an amended quote from them.

You were not satisfied with the quote and refused to pay the agreement fee.

You contacted Builder B for a quote.

Due to too much work Builder B declined to quote.

You had plans supplied to you by Builder C.

You also had a quote and plans from Builder D.

Builder E supplied you with some house plans and brochures.

Due to lack of funds you have not been able to build on the land.

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that a deduction is allowable for expenses incurred in gaining or producing assessable income, provided those expenses are not capital, private or domestic in nature.

Generally, expenses incurred relating to a rental property are deductible under section 8-1 of the ITAA 1997 if the property is rented or available for rent in the income year in which you claim the deduction.

Taxation Ruling TR 2004/4 considers deductions for interest incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. Federal Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steeles Case).

It is not necessary to show that the interest was incurred in producing income of a particular year. Interest that is otherwise deductible is not excluded from deductibility simply because no assessable income was derived in the relevant year.

The Commissioner limits the operation of Steeles Case to circumstances where:

· 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 of a private or domestic nature

· the period of interest outgoings prior to the derivation of relevant assessable income is not too long, taking into account the kind of income earning activities involved, that the necessary connection between the outgoings and assessable income is lost

· the interest is incurred with the one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

While this does not require constant on-site development activity, the requirement is not satisfied if the venture becomes truly dormant and the holding of the asset is passive, even if there is an intention to revive the venture at some time in the future.

You have purchased a block of land with borrowed funds with the intention of building a rental property for income producing purposes.

You have borrowed the funds to purchase the land and were waiting for the economy to pick up before you built.

You obtained a couple of quotes to build a house but never proceeded due to lack of funds.

The deductibility of costs of holding a piece of land on which a rental property was to be constructed was considered in Temelli v. FC of T 97 ATC 4716; (1997) 36 ATR 417 (Temellis Case). In that case, investors bought a vacant block of land, intending to erect a luxury house on it for rental. They paid some hundreds of dollars to have plans of the proposed house drawn up by an architect, but took no further action towards construction of the dwelling and renting it out. The Federal Court did not allow a deduction for interest and rates expenses incurred on the land, saying at ATC 4721; ATR 422:

In my view the taxpayers did not have the requisite degree of commitment to the relevant income producing activity. At all relevant times until 30 June 1991 the issue of whether, and if so when, a residence would be built by them for income earning purposes remained to be determined. Pending that decision the payment of interest was a payment to preserve the land as a capital asset and, accordingly, was of capital or of a capital nature. Whilst it can be accepted that the acquisition of the Mindarie Court land and having plans prepared in early 1989 is evidence of some commitment, those steps fall short of a commitment to the income producing element of the project, being the building of the home.

The Court contrasted the efforts made by these owners with those made by Mrs Steele, considered by the Federal Court in Steeles Case, quoting the efforts made by Mrs Steele, at ATC 4719, ATR 420:

she obtained the Councils assent to change of zoning, employed architects and engineers, entered into joint venture arrangements, and pursued the project with some tenacity until litigation with her collaborator put a complete stop to it. She demonstrated her commitment from the beginning by committing $1,000.000 to the venture plus the time, energy and considerable expenses of the subsequent architectural and engineering work, and negotiations with the local Council, sewerage authority and prospective joint ventures and financiers.

This indicates that continuing activity, aimed at eventually producing assessable income is required if the costs of holding a property with the idea of later producing income from it are to be deductible.

Your case is similar to Temellis Case in that you have obtained been supplied with possible plans from which to build a rental property and have entered into a sketch agreement. Additionally, where in Temellis case the construction was delayed because of external factors, the delay in your case is because of the lack of available funds.

In your case, we recognise you purchased the block of land with the intention of building a rental property and you have taken some steps toward the building process. However, as in the Timellis Case we consider that not having available funds for the project and the substantial time periods in which your attempts to build a property have been dormant indicates the lack of the requisite commitment to the income producing element of the project.

As discussed in TR 2004/4, the time to complete construction will be too long that the necessary connection between the interest outgoing and the derivation of income will be lost.

Therefore, you are not entitled to a deduction under section 8-1 of the ITAA for interest expenses incurred on your loan for the purchase of land with the intention to build a rental property and subsequently you will need to amend your prior tax returns for which you have claimed a deduction for the interest expenses.

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