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Ruling

Subject: rental property expenses

Question 1

Are you entitled to a deduction for the interest expenses incurred on borrowed funds used to pay an option fee?

Answer

No.

Question 2

Are you entitled to a deduction for the interest expenses incurred on borrowed funds used to repair the rental property?

Answer

Yes.

Question 3

Are you entitled to a deduction for the option fee or conveyance fee?

Answer

No.

Question 4

Are you entitled to a deduction for the cost of the initial repairs on the property?

Answer

No.

Question 5

Are you entitled to a deduction for the cleaning, pest control and key cutting for the property?

Answer

No.

Question 6

Are you entitled to a deduction for expenses incurred for advertising for a tenant, servicing the smoke alarms, rates, insurance and water charges for the property?

Answer

Yes.

Question 7

Are you entitled to a deduction for the decline in value of the depreciating assets in the property?

Answer

Yes.

Question 8

Are you entitled to a deduction for capital works?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2010

Relevant facts

The arrangement that is the subject of the ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

§ the application for private ruling,

§ agreement, and

§ further information received including details of costs incurred.

You signed an option agreement to purchase a residential property at the then market value.

You paid an upfront option fee.

You also incur an ongoing monthly option fee.

The upfront option fee alone shall be applied as a credit towards the purchase price in the event that the option is exercised by you.

You do not have to settle the property for over two years after the date of the option agreement.

The vendor financed the loan which you are paying off at a variable interest rate by direct deposit into their bank account.

Under the option agreement you are entitled to occupy the property either directly or through a third party. If this occurs, you will pay all the outgoings payable in relation to the property.

As part of the agreement, you are allowed to sub rent the property, obtain all income from the property and pay all expenses such as rates.

You have a tenant in the house and a managing agent.

Your tenant has use of the property.

The council rates are in the name of the vendor who still has title of the property.

The property was in good condition when you signed the contract. However, before a tenant moved in you had the property painted throughout inside and also had some repairs carried out.

You incurred costs for cleaning, pest control and key cutting prior to the property being tenanted.

The property was in the agent's hand from late 2010.

The property was not rented until early 2011.

You borrowed funds to pay for the option fee.

You borrowed money for repairs carried out in late 2010.

You incurred costs for the rates, insurance and water, as well as advertising for a tenant and servicing the smoke alarms.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 8-1.

Income Tax Assessment Act 1997 - Section 25-10.

Income Tax Assessment Act 1997 - Division 40.

Income Tax Assessment Act 1997 - Division 43.

Reasons for decision

Interest expense

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.

Taxation Ruling TR 95/25 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, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will generally be deductible. 

In your case, you are incurring interest on borrowed funds. Some of the borrowed funds were used to pay the option fee. The option fee is payable under the option agreement entered into. The agreement is not regarded as an income producing asset and therefore the associated interest expense incurred is not an allowable deduction.

The option and associated rights under the agreement is regarded as a capital gains tax (CGT) asset. The option fee and the associated interest expense on borrowing this fee form part of the cost base when calculating the capital gain or loss.

However, the interest incurred on borrowed funds used for repairs to the property which is being used for income producing purposes has a sufficient connection with your assessable rental income, therefore you are entitled to a deduction for the associated interest expense.

Option fee

The option fee provides you with an option to purchase the property. Such a fee is capital in nature and not an allowable deduction. Similarly, the conveyance fee for preparation of the option and pre purchase building inspection are also capital in nature and not deductible. These costs form part of the cost base when calculating your capital gain or loss.

Repairs to the property

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs incurred to premises that you held or used for income producing purposes. However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs where the expenditure is of a capital nature.

Taxation Ruling TR 97/23 indicates that expenditure for repairs to property is of a capital nature where:

§ the extent of the work carried out represents a renewal or reconstruction of the entirety, or  

§ the works result in a greater efficiency of function in the property, therefore representing an 'improvement' rather than 'repair', or

§ the work is an initial repair.

TR 97/23 states that repair costs are generally deductible where they are incurred during the period the property is held for income purposes and are attributable either to damage that occurs during the income use of the property or to defects that emerge suddenly during that time (paragraphs 66 and 72 TR 97/23).

Initial repair include expenditure incurred in remedying defects, damage or deterioration in existence at the date of acquisition.

In your case, you painted the property and carried out repairs to the property before the tenant moved in. Such work is not attributable to the income earning use of the property and is regarded as initial repairs. Similarly, there is no information to show that the bathroom repairs carried out during 2011 were due to the tenant's use of the property and are also regarded as initial repairs. Such work is capital in nature and is not therefore deductible under section 25-10 of the ITAA 1997.

Other costs

You incurred costs for cleaning, pest control and key cutting. Such costs were incurred before deriving any assessable rental income and are incurred at a point too soon to be incurred in gaining or producing your assessable income. Therefore no deduction is allowed for these costs.

However, costs incurred in advertising for a tenant and servicing the smoke alarms are an allowable deduction as they have a sufficient connection to the gaining of your assessable income. Similarly, the rates, insurance and water charges paid for the property which is being rented out are allowable deductions under section 8-1 of the ITAA 1997.

Depreciation

Section 40-25 of the ITAA 1997 allows a deduction for the decline in value (depreciation) of a depreciating asset you hold, to the extent the asset is used for a taxable purpose.

The table in section 40-40 of the ITAA 1997 identifies who is the holder of a depreciating asset. The effect of the table is that, unless another item provides otherwise, the legal owner of the depreciating asset is the holder (item 10 of the table).

However, item 6 of the table provides that the economic owner, and not the legal owner, is the holder where that entity (the economic owner) has possession, or an immediate right to possession, of the asset combined with a right, the exercise of which would make them the holder (for example, an option to acquire); and it is 'reasonable to expect' that the economic owner will become the holder by exercising that right or that the asset will be disposed of at their direction and for their benefit.

The effect of item 6 applying to an arrangement is that the entity in possession of the asset is taken to be the holder of the depreciating asset for the purposes of Division 40 of the ITAA 1997.

You use the stove and curtains in the property for rental purposes. You have a right to obtain legal title to them. During the period that the property is rented it is reasonable to expect that you would exercise this right.

You are the holder of the depreciating assets under item 6 of the table in section 40-40 of the ITAA 1997. Therefore you are entitled to a deduction for the decline in value of the depreciating assets under Division 40 of the ITAA 1997.

Capital works

Division 43 of the ITAA 1997 allows a deduction for certain capital works. The capital works deduction is only available for taxpayers with certain proprietary rights to the capital works. Section 43-110 of the ITAA 1997 explains that a capital works deduction is only available under Division 43 of the ITAA 1997 if you own, lease or hold the capital works. No more than one person may be entitled to the deduction in relation to that part of the capital works.

Capital expenditure on capital works by the owner of those capital works can only be deductible to that owner or a subsequent owner, that is, entitlement cannot be transferred to a lessee of those capital works.

In your case, you have not incurred the construction expenditure for the construction of the property. You are not considered to own, lease or hold the capital works for Division 43 of the ITAA 1997 purposes. As a result, you are not entitled to a deduction under Division 43 for the construction expenditure.