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Ruling

Subject: Property expenses

Question 1:

Can you claim a deduction for interest, rates and other costs incurred before your property was available for rent?

Answer: No.

Question 2:

Do the interest, rates and other costs incurred before your property was available for rent form part of the cost base of the property?

Answer: Yes.

Relevant facts

You purchased a property with the intention of leasing it out.

You did not lease it out as a squatter had taken up residence and asserted that they had a right to stay in the property. Due to your work commitments and family responsibilities you were unable to arrange or fund the legal action required to evict the squatter.

The squatter remained living in the property for two years. When you had the time you took legal action and the squatter was evicted.

You borrowed the funds to acquire the property, and so incurred interest expenses. You also had ongoing costs for rates, body corporate fees and insurance costs while the squatter remained on your property.

Reasons for decision

Summary

Two years is a considerable amount of time to have the property not available for rent and you made no continuing efforts during this time to have the squatter evicted and so make the property available for rent.

In these circumstances it is considered the length of time between the purchase of the property and the availability of the property for rent is so long that the necessary connection between assessable income and the interest, rates, body corporate fees, insurance and other holding costs was lost.

Therefore, you are not entitled to a deduction for these expenses where they were incurred before the property was available for rent.

However, as you are not entitled to a deduction for these expenses, they can be included in the cost base of the property for CGT purposes.

Detailed reasoning

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.

Interest

In Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. Taxation Ruling TR 2004/4, in considering the above decision, 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.

In your situation, the interest was incurred on borrowed funds used to acquire a property that was to be used in income earning activities. When you took over the property there was a squatter in residence. You took no steps to have the squatter evicted for two years, and so the property was unavailable for rent during this time.

Two years is a considerable amount of time to have the property not available for rent.

You have made no continuing efforts during the two years to have the squatter evicted and so make the property available for income producing purposes.

Because of this, it is considered the length of time between the purchase of the property and the availability of the property for rent is so long that the necessary connection between the interest and the assessable income was lost.

In these circumstances you are not entitled to a deduction for the cost of interest expense under section 8-1 of the ITAA 1997.

Rates, body corporate fees, insurance and other holding costs

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

Rates, insurance and some other outgoings on an income producing property are ordinarily deductible under section 8-1 of the ITAA 1997. In your case, these costs were incurred in relation to the property where a squatter was permitted to reside for two years after your purchase of the property

For the same reasons as discussed above with respect to interest, the length of time between the purchase of the property and the availability of the property for rent is so long that the necessary connection between the rates, body corporate fees, insurance and other outgoings and the assessable income was lost.

Therefore, you are not entitled to claim a deduction for these costs under section 8-1 of the ITAA 1997.

CGT cost base

The cost base of a CGT asset is defined in section 110-25 of the ITAA 1997.  It consists of five elements:

· money paid in respect of acquiring the asset

· incidental costs incurred in acquiring the asset or that relate to a CGT event that happens in relation to that asset

· non-capital costs of ownership of the CGT asset

· capital expenditure incurred to increase the asset's value

· capital expenditure incurred to establish, preserve or defend your title to the asset

The third element is the non-capital cost of owning a CGT asset if it was acquired after 20 August 1991.

These costs include:

· interest on money you borrowed to acquire the asset;

· costs of maintaining, repairing or insuring it; and

· council rates

Subsection 110-45(1B) of the ITAA 1997 states that expenditure does not form part of the second or third element of the cost base to the extent that you have deducted or can deduct it.

In your case, as they are not allowed as a deduction, the interest, rates, body corporate fees, insurance and other outgoings incurred before the property was available for rent may be included in the cost base of your property.