Edited version of private ruling

Authorisation Number: 1011604101925

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Ruling

Subject: Rental property - interest expenses and capital gain/loss

1. Are you entitled to a deduction for interest on an existing loan when it was originally used to acquire your principal place of residence but will be converted into an investment property after you acquire your spouse's share of the property?

Yes.

2. Are you entitled to a deduction for interest payments on a loan, where the proceeds of the loan are used to purchase your spouse's property, at market value, for the purpose of deriving rental income?

Yes.

3. Will your cost base for the property be considered separately for each of your interest in the property?

Yes.

This ruling applies for the following periods:

Year ending 30 June 2011

Year ending 30 June 2012

The scheme commences on:

1 July 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You own your principal place of residence jointly with your spouse.

Your family intends to move into a bigger property but would like to retain the smaller property as an investment property.

You want to buy out your spouse's share of the existing property based on the current market value as per bank's valuation from refinancing.

You will take an additional loan to buy out your spouse's share.

Relevant legislative provisions

Income Tax Assessment Act Section 8-1

Income Tax Assessment Act Section 102-20

Income Tax Assessment Act Section 104-10

Income Tax Assessment Act Section 108-7

Income Tax Assessment Act Section 110-25

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1 and 2

Summary

You are entitled to a deduction for interest on the outstanding loan amount where the funds are used to produce assessable income.

You are also entitled to a deduction for the interest on the additional loan you will be taking out to acquire your spouse's share of the property, at market value, for the purpose of deriving rental income.

Detailed reasoning

Interest deductibility

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides 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.

Taxation Ruling TR 95/25 provides that the deductibility of interest is determined by the use for which the borrowed money is intended. The use test looks to the application of the borrowed funds as the main criteria (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153). Where borrowed funds are used for investment purposes such as the acquisition of a rental property, the interest will be deductible to the extent that the property is used to produce assessable income.

In your case, you jointly own your principal place of residence which you intend to convert into an investment property after you acquire your spouse's share of the property. You will have a 100% ownership interest in the property, therefore the interest on the existing loan and the additional loan will be fully deductible as you are using the property for income-producing purposes.

Question 3

Summary

For capital gains tax (CGT) purposes, you will have to work out your capital gain or capital loss on the two separate interests you own with different dates of acquisition and each having their own cost base.

Detailed reasoning

CGT is the tax you pay on certain capital gains you make. You make a capital gain or a capital loss when a 'CGT event' happens (section 102-20 of the ITAA 1997). The most common CGT event A1 happens when you dispose of the asset to another party (for example disposal of a dwelling) (section 104-10 of the ITAA 1997).

Section 108-7 of the ITAA 1997 provides that individuals who hold a CGT asset as joint tenants are treated as if they were tenants in common who each owned a separate CGT asset comprising an equal interest in the asset.

For CGT tax purposes, you are considered to own two separate assets in relation to the investment property (Taxation Determination TD 2000/31). In your case, the first CGT asset will be the 50% interest in the property when the property was originally acquired by you and your spouse (Interest 1). The second CGT asset will be the 50% interest in the property that you intend to acquire from your spouse (Interest 2).

Calculating a capital gain and cost base

For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your CGT asset.

In working out your capital gain, you determine the cost base of the CGT asset involved in the CGT event.

Section 110-25 of the ITAA 1997 sets out the five elements that form part of the cost base.

The first element is made up of money paid or required to be paid to acquire the CGT asset.

In your case, the first element of the cost base for Interest 1 will be 50% of the acquisition cost at the time of the purchase of the property.

The four remaining elements that may form part of the cost base or reduced cost base are listed in the Guide to capital gains tax 2009-10 (NAT 4151) (the Guide) in our website under the heading 'What is the cost base?' and What is the reduced cost base?'

In reference to Interest 2, there are special rules that apply if the acquisition is between family members or a related party. Such a transaction is considered to be a 'non-arms length' transaction and require modifications to the relevant cost base and capital proceeds used to calculate your capital gain or loss.

You are said to be dealing at arm's length with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction.

The market value substitution rule takes effect if you did not deal at arm's length with another entity in connection with the event. The market value substitution rule replaces the sale proceeds with the market value of the asset at the time of the CGT event.

As you are purchasing your spouse's share at market value, this constitutes an arm's length transaction.

In your case, the first element of your cost base for Interest 2 would be equal to one-half of the market value of the property when the contract is entered into for the disposal or if there is no contract, when the change of ownership occurs (section 104-10 of the ITAA 1997).

In working out the market value of your property, Taxation Determination TD 10 lists what are acceptable valuations for CGT purposes.

Where the market value of a property needs to be determined, you can choose to: 

· obtain a detailed valuation from a qualified valuer, or

· compute your own valuation based on reasonably objective and supportable data.

In your case, the current market value of your property has been determined by the bank that has provided refinancing. As there is insufficient information to establish whether or not the market value of your property meets what has been set out in TD 10, the Commissioner is not in a position to establish whether the bank's valuation is acceptable or not. It is recommended that you ensure that the market value you use for your cost base for Interest 2 meets TD 10.

Please note that the Determination makes the point that the Commissioner may challenge valuations where appropriate. 

Again, please refer to the Guide for the four remaining elements of the cost base or reduced cost base for Interest 2.

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