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Ruling

Subject: Property rented to a related party

Question 1

Is a deduction allowable for interest incurred on a loan to be obtained by a Family Trust in order to purchase units in a proposed unit trust which will use the funds to acquire a rental property, including a period in which the property will be rented to the trustees?

Advice/Answers

Yes

Question 2

If so, can this deduction be offset against other income derived by the Family Trust?

Advice/Answers

Yes

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

X intend to sell their current residence and purchase land on which they will erect a new residence.

At the same time it is intended to purchase an investment property through a new unit trust (UT). The existing family trust (FT) will own 100% of the units in UT. X are the trustees of FT and will also be the trustees of UT.

During the construction period for their new residence it is proposed that X will reside in the investment property and will pay rent at a commercial rate to UT. When the new residence is completed they will move out of the rental property which will then be placed on the open market and rented at arms length for an indefinite period.

FT will borrow the funds required to purchase the units in UT from a lending institution. This loan will be secured against the rental property and the personal assets of the trustees.

It is expected that initially interest deductions incurred by FT will exceed the income distributed by UT from the rental income derived.

Relevant legislative provisions

Income Tax Assessment Act 1997 - section 8-1

Reasons for decision

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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense(Lunney v. FC of T; (1958) 100 CLR 478,

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47, and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v.FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling TR 95/25 sets out the deductibility of interest expenses. The interest on money borrowed must be characterised by reference to the use to which the borrowed funds have been put. Interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the income producing activity (Federal Commissioner of Taxation v. JD Roberts; Federal Commissioner of Taxation v. Smith 92 ATC 4380; (1992) 23 ATR 494).

Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in FC of T v Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will be deductible to the extent that the property is used to produce assessable income.

Taxation Ruling IT 2167 discusses arms length and non-arms length letting of a residence. Generally the approach to be followed is based on whether the rent charged by the owner represents a normal commercial rent. Where property is let at a commercial rent then, apart from the effect of any express statutory provision to the contrary, expenses incurred in letting the property under an arm's length arrangement is fully deductible (FC of T v Janmor Nominees Pty Ltd 87 ATC 4813). That is, the arrangement is treated no differently for income tax purposes from any other owner in a comparable arms length situation (paragraph 13 of IT 2167).

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 this instance, the fact that the property to be purchased by UT will initially be let to the trustees at a commercial rate whilst a new residence is constructed for them is not evidence to show that FT had another purpose or intention in acquiring the units other than to derive assessable income. The property will be leased on the open market once the trustees' new house is completed and in these circumstances it is considered that the expectation to gain or produce assessable income is reasonable. Therefore a deduction is allowable under section 8-1 of the ITAA 1997.

Question 2

In this case, FT will borrow funds from a lending institution which will be used to purchase 100% of the units in UT. UT will acquire a rental property which it intends to hold for an indefinite period of time and to rent the property out for the purpose of producing assessable income. FT has the expectation that it will receive a return on its investment in the units purchased as the rent to be charged, at all times, will be the commercial rate that is applicable to the property when compared to similar properties in the area.

Notwithstanding the intention to initially rent the property to the trustees whilst a new residence is being constructed for them, the rent will always be charged at a commercial rate. Therefore, FT will be in no worse position, with the trustees as tenants, than if the property had been leased at arms length from the time of purchase.

The interest incurred by FT in respect of the loan to acquire the units in UT would therefore be deductible under section 8-1 of the ITAA 1997 as the requirements of that section have been met. As long as the property is being rented at a commercial rate, the trust will continue meeting the requirements of section 8-1 of the ITAA 1997 and is therefore entitled to claim the interest expenses charged on the loan to acquire the units.

Therefore the outgoing for the interest expense may be claimed against other income derived by FT should there be insufficient distributions from UT to cover the outgoing.