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Ruling

Subject: rental property

Question 1

Are you entitled to 100% of the income and allowable deductions in relation to the property?

Answer

No.

Question 2

Are you entitled to 50% of the income and allowable deductions in relation to the property?

Answer

Yes.

Question 3

Are you entitled to a deduction for your share of the cost of the rates and water charges incurred?

Answer

Yes.

Question 4

Are you entitled to a deduction for the cost of the painting and clean up and other initial repairs on the property?

Answer

No.

Question 5

Are you entitled to a deduction for your share of the vendor fees paid?

Answer

Yes.

Question 6

Is there a capital gains tax event C1 in relation to the deposit?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2011

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,

· contract of sale, and

· fixed term tenancy agreements.

You and your spouse signed a contract to purchase a residential property subject to finance approval. The finance approval was due in approximately nine months later.

You intended to own the property in equal portions with your spouse.

Your spouse then signed a fixed term tenancy agreement with the owner/vendor which showed them as the only tenant. It was agreed to rent the property.

This agreement allowed access to the property before settlement. Permission was given to sublet the property. It was the intention to use the property for rental purposes up to the proposed settlement.

The deposit paid within seven days of this fixed term tenancy agreement being signed was non refundable.

Access to the property was granted for the purpose of clean up and minor renovations and survey of property boundary on receipt of the deposit.

All renovations were to be non-structural.

You were also required to pay the rates, water charges and any necessary repairs for the period you had access to the property.

You also paid for repairs to the property necessary to bring the property to a rentable state.

A subsequent fixed term tenancy agreement was entered into showing your spouse as the only leasor and an unrelated third party as the tenants.

You received a weekly rent from the third party for the use of the property.

Due to finance not being approved, settlement of the contract never occurred. The loan application was in joint names.

At this time the agreement to access the property ceased as did the rental arrangement.

There was no reimbursement for any of the holding costs incurred or for the deposit.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Division 43.

Income Tax Assessment Act 1997 Section 102-20.

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Section 104-20.

Income Tax Assessment Act 1997 Section 116-25.

Reasons for decision

Rental income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Rent is regarded as ordinary income and therefore assessable under subsection 6-5(2) of the ITAA 1997.

Taxation Ruling TR 93/32 Income tax: rental property - division of net income or losses between co-owners refers to the division of the net income or loss between joint owners of a rental property. Although you never became a joint owner in the property, the principles in the ruling are relevant in your circumstances.

TR 93/32 states that the income/loss from a rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title.

In your case, you and your spouse both signed the contract for sale to purchase a rental property. Although you never became the legal owner of the property, you intended to own the property as joint tenants with your spouse. It is considered that you and your spouse both had an equal interest in the property.

Therefore, any rental income or expenses from the property is shared equally. That is you are only assessable on 50% of the rental income derived from the property. Similarly, any costs incurred in relation to the property are also shared equally.

Rates and water charges

Section 8-1 of the 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, or relate to the earning of exempt income, or a provision of the ITAA 1997 prevents it.

Costs incurred for rates and water charges for the property which is being used to produce rental income are allowable deductions under section 8-1 of the ITAA 1997. These costs have a sufficient connection to the gaining of your assessable income.

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).

Paragraph 59 of TR 97/23 states that expenditure incurred on an initial repair after the property is acquired, if the expenditure is incurred in remedying defects, damage or deterioration in existence at the date of acquisition, is capital expenditure and is not therefore deductible under section 25-10 of the ITAA 1997. TR 97/23 further states that the cost of effecting an initial repair is still not deductible even if some income happens to be earned after acquisition but before the repair expenditure is incurred.

In your case, when access to the property was acquired there was work required to bring the property to a rentable state. The property was painted and rubbish removed to make the property rentable. The works carried out were not occasioned by factors that occurred during your period of income production, that is, the need for the work arose before your income producing use of the property.

The work carried out prior to the tenant moving in 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 repairs carried out after the tenant moved in 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.

Furthermore the costs such as cleaning 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.

Please note, in your circumstances, no deduction is allowable under Division 43 of the ITAA 1997 for the capital expenditure. 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.

Vendor's fee

The weekly fee paid to the vendor allowed you to access the premises and use the property for rental purposes.

Taxation Ruling TR 2004/4 considers deductions for interest expenses incurred 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) as well as the decisions in the Full Federal Court.

Although the ruling discusses interest expenses, the principles can also apply to the vendor's fees and holding costs such as rates and water charges.

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. Taxation Ruling 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.

TR 2004/4 also considers deductions following the cessation of the relevant income earning activities and states if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period, then a deduction is still allowed. However, if the expenses are incurred for a reason that is not associated with the former income earning activities, no deduction will be allowable.

In your case, the vendor has given you access to the property before settlement. Your intention in gaining access to the property was to use it for producing assessable rental income. It is considered that there is sufficient nexus between the vendor's fees and your assessable rental income. The fact that you did not receive rental income for the full period does not break the nexus to your assessable rental income. Therefore a deduction is allowable under section 8-1 of the ITAA 1997 for the amounts paid to the vendor for access to the property.

Capital gain

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a capital gains tax (CGT) event happens. There are a wide range of CGT events covering many different situations, each with its own conditions. 

If the purchaser defaults, the vendor terminates the contract and the purchaser forfeits the deposit, there may be a surrender, forfeiture or abandonment of the rights such that there is an ending of the purchaser's ownership of the rights. If so, CGT event C2 happens (subsection 104-25(1) of ITAA 1997). Under subsection 104-25(2) of the ITAA 1997, the time of the CGT event is when the rights end, that is, at the time the contract is terminated.

CGT event C1 in section 104-20 of ITAA 1997 (about a loss or destruction of a CGT asset) might also happen if a purchaser defaults, the vendor terminates the contract and the purchaser forfeits the deposit. A purchaser's contractual rights might be said to be lost or destroyed in these circumstances.

As both CGT event C1 and CGT event C2 may apply if a purchaser forfeits a deposit, subsection 102-25(1) of the ITAA 1997 provides that the CGT event that is the most specific to the situation is the one to use. The circumstances surrounding the purchaser's default determines which is the more specific CGT event.

Paragraph 123 of Taxation Ruling TR 1999/19 states:

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 capital gain or capital loss arising from the CGT event C1 is calculated by comparing the capital proceeds received as a result of the event with the cost base of the asset. If the capital proceeds are greater than the cost base, then a capital gain has been made. Alternatively, if the capital proceeds are less than the reduced cost base, the result is a capital loss (subsection 104-25(3) of the ITAA 1997)

Usually, no capital proceeds are received by a defaulting purchaser on the ending of their contractual rights. 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. However, the general rule for substituting market value if no capital proceeds have been received, does not apply to CGT event C1 (section 116-25 of the ITAA 1997).

The cost base of a CGT asset is generally the cost of the asset plus certain other costs associated with acquiring, holding and disposing of the asset (section 110-25 of the ITAA 1997).

Therefore where 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.

As the contract is in joint names, the capital loss is shared accordingly. 

Please note that capital losses may only be used to offset capital gains. That is, you cannot deduct a capital loss from your assessable income. Any unused capital losses may be carried forward to future income years until such time as you have a capital gain against which they can be offset.