Edited version of private advice

Authorisation Number: 1052310353894

Date of advice: 11 Oct 2024

Ruling

Subject: Rental property deductions

Question 1

Can you claim a deduction for interest expenses on funds borrowed for land purchased before a permanent structure is legally able to be occupied and available for rent?

Answer

No.

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all 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.

Although the requirements of section 8-1(1) of the ITAA 1997 are met, a deduction is not allowable due to the limitation of section 8-1(2)(d) and section 26-102 of the ITAA 1997.

Question 2

Can you claim a deduction for interest expenses on funds borrowed for the construction of an investment property?

Summary

Yes.

The interest on the funds borrowed for the construction of the building is deductible prior to assessable income being earned as it meets the criteria in paragraph 9 of Taxation Ruling TR 2004/4 Deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities (TR 2004/4).

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

On DD MM 20XX, you purchased a vacant block of land for $XX plus costs with the intention of developing the land for investment use. The block of land was purchased to develop a purpose-built building for the exclusive use of investment only.

You acquired a loan from a bank to purchase the block of land. This loan was an interest only loan for land when the block of land was bought.

On DD MM 20XX, your bank merged the initial loan for the block of land to include both land and construction as a single loan.

On DD MM 20XX, construction of a dwelling on the vacant block of land had commenced.

When construction is complete the dwelling will be rented out.

It is estimated that the dwelling will not be ready until MM 20XX with an occupancy certificate being granted during the same time.

The only expenses incurred to date are the interest on the loan, the council rates, the water rates and the land tax.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 8-1(2)(d)

Income Tax Assessment Act 1997 section 26-102

Reasons for decision

Question 1

Can you claim a deduction for interest expenses on funds borrowed for land purchased before a permanent structure is legally able to be occupied and available for rent?

Summary

No. Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all 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.

Although the requirements of section 8-1(1) of the ITAA 1997 are met, a deduction is not allowable due to the limitation of section 8-1(2)(d) and section 26-102 of the ITAA 1997.

Question 2

Can you claim a deduction for interest expenses on funds borrowed for the construction of an investment property?

Summary

Yes. The interest on the funds borrowed for the construction of the building is deductible prior to assessable income being earned as it meets the criteria in paragraph 9 of Taxation Ruling TR 2004/4 Deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities (TR 2004/4).

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that 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, or is necessarily incurred in carrying on a business for that purpose. However, you cannot deduct a loss or outgoing under this section that is of a capital, private or domestic nature.

Taxation Ruling TR 2004/4 considers the deductibility of interest expenses incurred prior to the commencement of income earning activities, and interest expenses incurred after income earning activities have ceased.

The view that the deductions could be claimed under section 8-1 by the taxpayer in this situation is supported under TR 2004/4 where:

•                     the funds borrowed for the property were 'solely intended to be employed in income earning operations'

•                     'the period of interest outgoings prior to the derivation of relevant assessable income is not so long'

•                     'continuing efforts were undertaken in pursuit of' assessable income.

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling TR 95/25 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 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income.

The Commissioner's view on whether interest deductions are allowable prior to the commencement of income earning activities, and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) are outlined in Taxation Ruling TR 2004/4.

In Steele's case the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. TR 2004/4 concludes 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.

While Steele's case deals with the issue of interest, the principles can be applied to other types of expenditure including local council, water and sewerage rates.

TR 2004/4, in considering the final of the above conditions, states that a test of 'continuing efforts' would need to be set within the context of the normal time frames of the relevant industry.

However, if a venture becomes truly dormant and the holding of the asset is passive, relevant interest will not be deductible even if there is an intention to revive that venture sometime in the future.

In your case you have been making continuous efforts in relation to the building of the rental property since you purchased the land.

Interest expense on holding vacant land - limitation

Subsection 26-102(1) of the ITAA 1997 states that if:

(a)           at a particular time, you incur a loss or outgoing relating to holding land (including interest or any other ongoing costs of borrowing to acquire the land); and

(b)           at the earlier of the following (the critical time):

(i)            that time;

(ii)            if you have ceased to hold the land - the time just before you ceased to hold the land;

there is no substantial and permanent structure in use or available for use on the land having a purpose that is independent of, and not incidental to, the purpose of any other structure or proposed structure;

You can only deduct under this Act the loss or outgoing to the extent that the land is in use, or available for use, in carrying on a business covered by subsection (2) at the time applying under subsection (3).

This means that from the introduction of the legislation on 1 July 2019 income tax deductions to taxpayers will be denied for losses and outgoings incurred in holding vacant land, regardless of when acquired, to the extent the land is not at the time of incurring the expense or outgoing:

•                     used or held available for use by the entity in the course of carrying on a business in order to earn assessable income; or

•                     used or held available for use in carrying on a business by:

o        an affiliate, spouse or child of the taxpayer; or

o        an entity that is connected with the taxpayer or of which the taxpayer is an affiliate

Section 26-102(4) states that for the purposes of paragraph (1)(b), treat a building as not being a substantial and permanent structure if it is residential premises constructed, or substantially renovated, while you hold the land unless:

(a)           the residential premises are lawfully able to be occupied; and

(b)           the residential premises are:

(i)            leased, hired or licensed; or

(ii)            available for lease, hire or licence.

This means that land is vacant until the structure is lawfully able to be occupied and used or available for use (e.g. no deduction during construction).

Expenses for which deductions will be denied that would ordinarily be a cost base element (such as borrowing expenses and council rates) may be included in the cost base of the asset for capital gains tax (CGT) purposes when sold.

In your circumstance you purchased a block of land, built a dwelling on it, and will rent the property out when the construction is complete and an occupancy certificate is obtained.

Conclusion

When there was no substantial and permanent structure in use or available for use on the block of land, deductions are not allowed for losses and outgoings incurred (the interest expenses) in holding the vacant block of land.

The interest on the funds borrowed for the construction of the building is deductible prior to assessable income being earned as it meets the criteria in paragraph 9 of Taxation Ruling TR 2004/4.

The interest expenses incurred on the combined land and construction loan, when the property is rented or genuinely available for rent, are deductible.

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