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Ruling

Subject: Rental deduction - interest

Question

Should the amount you claim as interest deductions on a rental property that is used partly to produce assessable income and partly as a personal residence be apportioned using the number of rooms in the home?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

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 intend to purchase a three bedroom house which is currently being built.

You intend to live in the house and rent out the two vacant bedrooms in order to generate assessable income.

You do not intend to utilise a real estate agent to find tenants, instead you will actively seek them out yourself.

You will have a formal tenancy agreement in place with each of your tenants.

You will determine the market value of the rent by researching similar properties in the area and you will rent the property at this market value.

The rent you charge tenants may be increased to include amounts for food and utilities, or alternatively you will split the bills among people living in the house. You are yet to make a decision on how you will approach this matter.

You consider that one-third of the house is for personal use and two-thirds for assessable income generating purposes.

The house will be financed with a cash deposit and the remainder via a bank loan.

You intend to borrow an amount to purchase the house. You want to split the loan into two separate facilities to enable you to monitor it easily. Facility one would be for 1/3 of the borrowing amount and facility two would be for 2/3 of the borrowing amount to represent the split of personal and income generating portions (as previously stated).

Instead of adding all interest and other costs of the two facilities together (for example, annual fees and monthly account keeping fees) and multiplying it by two-thirds to calculate the deduction portion, you would like to use the costs of facility two as the basis for your interest deduction

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Detailed reasoning

Available to rent

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.

To claim expenses that relate to your rental property, you must be holding the property for the purpose of gaining or producing assessable income. Generally, a property is considered to be held for the purpose of gaining or producing assessable income where it is either tenanted, listed with an agent as being available for tenancy or where the owner is making active and bona fide efforts to let the property.

Paragraph 25 of Income Tax Ruling IT 2167 states that when determining whether the property was available for rent, only the periods of vacancy should be taken into account where it is established that active and bona fide efforts were made to let the property at a commercial rate.

Unless active and bona fide efforts are being made to attract new tenants during periods of vacancy, it is considered that the property is not available for rent and not being used to produce assessable income. The losses and outgoings are therefore limited or apportioned.

In order to claim a deduction for your interest expenses, the property must be tenanted or you must be actively searching for tenants to rent the property at market value.

Dual purpose borrowings

Taxation Ruling TR 95/25 deals with deductions for interest under section 8-1 of the ITAA 1997. Interest is deductible where the expense has a sufficient connection with the gaining or producing of assessable income and it is not of a capital, private or domestic nature. To establish that there is a sufficient connection between incurring an interest expense and the gaining or producing of assessable income, regard must be given to all the circumstances including the use to which the borrowed funds are put.

Taxation Determination TD 93/13 says that if borrowed funds are used only partly to produce assessable income, only that part of the interest which relates to the production of assessable income is an allowable deduction.

Apportionment

Generally, if there is a dual purpose asset, the funds borrowed are considered to have the same dual purpose. In such a case, the principles of apportionment will apply to allow a deduction for the interest on the borrowing to the extent to which the asset is used for an income producing purpose.

The issue of apportionment is discussed at paragraph 14 of TR 95/33 which states that when it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both 'fair and reasonable' in all circumstances (Ronpibon Tin (1949) 78 CLR 47 at 59; 8 ATD 431 at 437).

When an identified part of a residence is rented in an arms length transaction (for example a bedroom with access to general living areas), the most appropriate method of apportionment is considered in paragraph 10 of IT 2167. It considers that apportionment should be made on a floor area basis, which is by reference to the floor area of the residence to which the tenant has sole occupancy. It should also include a reasonable figure for access to the general living areas including garage and outdoor areas.

Apportioning the interest you incur using the number of rooms in the house would not provide a fair and reasonable estimate of the proportion of the home used to produce assessable income. This method would not accurately reflect each tenant's usage of the common areas of the house. Therefore, splitting your loan into 2 portions to reflect the number of rooms used to generate income and the room used for private purposes will not provide a fair and reasonable estimate of the deductible interest.

A method of apportionment which would be considered fair and reasonable in your circumstances is represented by the following calculation:

(Area of both tenants bedrooms + two-thirds of common area) divided by (Total area)

The above calculation will provide a fair and reasonable estimate of the portion of the home that is used to produce assessable income. It will reflect each tenant's usage of the bedrooms they occupy and the common areas of the home. Therefore, this method of apportionment is considered a fair and reasonable basis to determine the amount to claim as a deduction for interest under section 8-1 of the ITAA.

Inclusion of utilities in rent

Paragraph 11 of IT 2167 details that when a tenant, in addition to paying rent is required to make a separate contribution to specific variable or running costs such as electricity, that amount will be considered to be assessable income. If the arrangements are such that the separate contribution is made on a precise sharing of costs basis, the assessable income will be offset by allowable deductions. If the separate contribution is a fixed amount, income tax deductions will be allowed for the part of the variable or running costs attributable to the tenant's use of the relevant facilities.

Therefore, if the rent you charge your tenants include amounts for utilities and running costs this separate contribution will be considered assessable income.