Edited version of your private ruling

Authorisation Number: 1012438243702

Ruling

Subject: Interest deductions and Part IVA

Questions:

1. Is the cost base of investment property the market value of the property at the time it was first rented?

Answer:

Yes.

2. Are you entitled to a deduction for the interest incurred on funds borrowed to rebuild the rental property?

Answer:

Yes.

3. Will Part IVA apply to the arrangement?

Answer:

No.

This ruling applies for the following period

Year ending 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts

You purchased a property (property A) and used it as your main residence.

You married a number of months later and both of you, your spouse and your children, lived in the property until 200X.

In 200X, you and your spouse purchased another (property B) and that property then became your main residence.

Property A was then used as a rental property.

You are the sole owner of property A and property B is held in joint names.

Property A was rented out until 200Y when the tenants vacated the property.

Due to the state of the property at that time, it was originally decided that property A would be demolished and a new home built in its place to be used as your new main residence.

You have now changed your mind and you and your spouse plan instead to sell property B and you will also sell a 50% interest in property A to your spouse at market value.

You plan to buy another property elsewhere, in joint names, to be used as your new main residence.

You plan to build a new investment property on property A, although no plans have yet been submitted to council.

Your spouse will borrow money to buy the 50% share in property A from you and you will use those funds to help pay for your new main residence.

You will include any capital gain made on the sale of 50% of property A in your personal income tax return.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 8-1

Income Tax Assessment Act 1997 - Division 118

Income Tax Assessment Act 1997 - Section 118-192

Income Tax Assessment Act 1936 - Part IVA

Income Tax Assessment Act 1936 - Section 177A

Income Tax Assessment Act 1936 - Section 177C

Income Tax Assessment Act 1936 - Section 177D

Income Tax Assessment Act 1936 - Section 177F

Reasons for decision

Cost base

Division 118 of the Income Tax Assessment Act 1997 (ITAA 1997) deals with capital gain and capital loss exemptions. Subdivision 118-B of this Division contains the CGT main residence exemption. The exemption disregards a capital gain or capital loss a taxpayer makes from a CGT event that happens to a dwelling, or their ownership interest in a dwelling, which is their main residence.

In your case, property A was your main residence from the date of purchase until 200X. It was also the main residence of your spouse and children at all relevant times. Property A was then used as a rental property.

Section 118-192 of the ITAA 1997 contains a special rule which applies when the taxpayer loses the entitlement to a full main residence exemption because the dwelling was used for income producing purposes for the first time after 7.30pm (by legal time in the Australian Capital Territory) on 20 August 1996.

The conditions of section 118-192 of the ITAA 1997 are as follows:

· only a partial main residence exemption would be available under Subdivision 118-B of the ITAA 1997 because the dwelling was used for the purpose of producing assessable income during the taxpayer's ownership period (paragraph 118-192(1)(a))

· the income producing use started after 7.30 pm (by legal time in the ACT) on 20 August 1996 (paragraph 118-192(1)(aa) of the ITAA 1997), and

· the taxpayer would have been entitled to a full main residence exemption if they had entered into a contract to dispose of the dwelling just before the first time it was used for the income producing purpose (paragraph 118-192(1)(b) of the ITAA 1997).

If these conditions are satisfied, the taxpayer is taken to have acquired the dwelling at the time they first started using it for income producing purposes, for its market value at that time, as provided by subsection 118-192(2) of the ITAA 1997.

In your case, you would only be entitled to a partial main residence exemption in relation to property A as it was used to produce assessable income as a rental property and this use started in 200X, after 20 August 1996. If you had entered into a contract to dispose of the property before it was first used to produce assessable income, you would have been entitled to the full exemption.

Therefore, pursuant to section 118-192 of the ITAA 1997, you are taken to have acquired property A for its market value at the time it was first used for an income producing purpose.

Interest expenses

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. 

Taxation Ruling TR 95/25 considers the deductibility of interest. 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 Federal Commissioner of Taxation 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 criteria. Where borrowed funds are used to acquire an income producing asset (for example, a rental property), the interest on the borrowed funds is considered to be incurred in gaining or producing assessable income and will be an allowable deduction. Alternatively, where borrowed funds are used for a private or domestic purpose, the interest on the borrowed funds will not be an allowable deduction.

In your case, you intend to re-build an investment property on property A, and may borrow additional funds to do this.

As the borrowed funds will be used to re-build the investment property, an income producing asset, you would be entitled to a deduction for your portion of interest expenses incurred

Application of Part IVA

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance provision that can apply in certain circumstances. Part IVA gives the Commissioner the power to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

In broad terms, Part IVA will apply where the following requirements are satisfied:

· there is a scheme (see section 177A);

· a taxpayer has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme (see section 177C); and

· the dominant purpose of a person who entered into or carried out the scheme, or any part of the scheme, was to enable the relevant taxpayer to obtain a tax benefit in connection with the scheme, or to enable the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (paragraph 177D(b)).

The application of Part IVA depends on a careful weighing of all the relevant facts and surrounding circumstances of each case.

In your case, what you are proposing is a 'scheme' capable of attracting the operation of Part IVA. However, when considered in conjunction with the factors in paragraph 177D(b) of the ITAA 1936, all these factors either point against the application of Part IVA or are neutral. Therefore, Part IVA will not apply to this arrangement.