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Ruling

Subject: Interest expenses and capital losses

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for interest expenses incurred in taking out a loan to pay a deposit on an investment property?

Answer

No.

Question 2: Did you make a capital loss when capital gains tax (CGT) event C1 happened on the forfeiture of your deposit?

Answer:

Yes.

Question 3: Can you offset your capital loss from either current year, or future year capital gains?

Answer:

Yes.

This ruling applies for the following periods

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

During 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 are not in business of purchasing property. You intended to buy a single house on two acres as an investment property. On signing the contract you paid 10% deposit. You had X months settlement arrangement.

The property was being purchased at arm's length with no finance clause being included in the contract.

The properly was leased to a renter and you were to leave that renter in place after settlement.

You could not obtain the finance during the settlement period and had to forfeit your deposit. You paid interest on this money during the entire settlement period.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1
Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 subsection 102-25(1)

Income Tax Assessment Act 1997 section 104-20

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 subsection 116-30(1)

Reasons for decision

Taxation Ruling TR 2004/4 considers the deductibility of interest expenses incurred prior to the commencement of income earning activities, arising from the implications of the High Court ruling in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case). In Steele's case, the High Court considered deductions for interest expenses incurred on funds borrowed to purchase land intended to be developed for income production.

TR 2004/4 concludes that interest expenses incurred before the commencement of income-earning activities will be incurred in producing assessable income where:

· the interest is not incurred too soon, (is not a prelude to those activities);

· the interest is not private or domestic;

· the interest is not incurred so long before the derivation of relevant assessable income that the necessary connection between the expenses 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 made in pursuit of that end. 

In your case, you entered into a contract to purchase an income-producing asset. Between the contract date and the settlement date you could not acquire capital to finance the property. As the contract had no finance clause included you forfeited the deposit you had paid.

Your activities were preliminary to the undertaking that would have produced your assessable income. On the settlement date, you could not secure the income-producing asset as no clause in the contract allowed further time to obtain finance and therefore the deposit was forfeited.

It is considered that your interest expenses were incurred too soon to be incurred in the gaining or producing of your assessable income. As such, you are not entitled to a deduction for interest expenses incurred in borrowing funds to pay a deposit.

CGT event

Taxation Ruling TR 1999/19 Income tax capital gains: treatment of forfeited deposits (TR 1999/19) explains the capital gains tax (CGT) consequences that apply when a deposit paid by a purchaser is forfeited.

If a purchaser forfeits a deposit, either CGT event C1 in section 104-20 of the ITAA 1997 (about a loss or destruction of a CGT asset) or CGT event C2 in section 104-25 of the ITAA 1997 (about a surrender, forfeiture or abandonment of the rights, such that there is an ending of the purchaser's ownership of rights) happens. Subsection 102-25(1) of the ITAA 1997 states that if more than one CGT event can happen, the one you use is the one most specific to your situation.

The circumstances surrounding the purchaser's default in each case determines which is the more specific CGT event.

If the circumstances are of a voluntary nature, there is as a result a surrender, abandonment or forfeiture by the purchaser of their contractual rights and CGT event C2 is the more specific CGT event. (Even if there might also be a destruction of the purchaser's contractual rights the surrender, abandonment or forfeiture is more specific). For example, if a purchaser defaults simply by changing their mind, deciding to invest elsewhere or the like, CGT event C2 is the more specific CGT event.

If the circumstances are of a genuinely involuntary nature, there is a loss or destruction of the contractual rights and CGT event C1 is the more specific CGT event. For example, if a purchaser defaults because their finance fails, or because of extenuating personal circumstances, e.g., death of spouse, severe illness, natural disaster, CGT event C1 is the more specific CGT event.

The CGT event happens at the time the contract is terminated.

In your case CGT event C1 will apply for the following reasons:

· you entered into a contract to purchase an investment property;

· you arranged to extend the existing six month settlement period by one month in an effort to obtain the necessary finance to complete the purchase; and

· ultimately you were unable to finance the balance payable by the settlement date;

which meant that the forfeit of your deposit was genuinely involuntary in nature.

Capital loss

Usually, no capital proceeds are received by a defaulting purchaser on the ending of their contractual rights. Subsection 116-30(1) of the ITAA 1997 states that if an entity receives no capital proceeds from a CGT event, generally the entity is taken to have received the market value of the CGT asset that is the subject of the event.

Paragraph 133 of TR 1999/19 states that if a CGT event C1 is the most specific CGT event, the market value substitution rule does not apply and a bona fide purchaser is entitled to a capital loss of the amount of the deposit forfeited plus incidental costs regardless of the market value of the contractual rights of the underlying real estate.

In your case you did not receive any capital proceeds from CGT event C1 happening. Under CGT event C1 the market value substitution rule does not apply. Therefore you have made a capital loss equal to the amount of the deposit paid plus any incidental costs.

Your sales contract to purchase your investment property was terminated and your deposit forfeited during 2011, X months after you entered into the contract to purchase. As a result CGT event C1 has happened in the year ended 30 June 2012.

You will be able to either offset your capital loss against any current year capital gains (capital gains made in the year ended 30 June 2012), (if you make a current year capital gain) or carry forward the capital loss to be applied against any future year capital gains. Please note that current year capital losses are first deducted from any current year capital gains prior to any unapplied capital losses from previous years being used. Capital losses can be carried forward indefinitely.