Edited version of your written advice

Authorisation Number: 1051187423653

Date of advice: 6 February 2017

Ruling

Subject: Rental property

Question 1

Are you carrying on a rental property business?

Answer

No.

Question 2

Are you entitled to a deduction for rates and utilities incurred before property was rented?

Answer

Yes.

Question 3

Are you entitled to a deduction for the set up costs for the property?

Answer

No.

Question 4

Are you entitled to claim a capital works deduction for the building improvements after the property is rented?

Answer

Yes.

Question 5

Are you entitled to a deduction for the decline in value for the depreciating assets used for income producing purposes?

Answer

Yes.

Question 6

Are you entitled to a deduction for the cost of plants and installing gardens?

Answer

No

Question 7

Where the deductible rental expenses are more than your rental income, can the loss reduce your other ordinary assessable income?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 201Y

The scheme commenced on

1 July 201X

Relevant facts

You purchased a property to be used for holiday rental. You are the sole owner of the property.

A few months later, you began work on the property.

You applied for and were given an ABN.

You incurred expenses for rates and utilities during the period before the property was available for rent.

You also incurred set up costs in preparing the property for rental.

The property was rented a few months after; on a holiday rental basis and earned income.

You provide breakfast provisions and other items for all guests.

You previously cleaned the property after periods of rental, but have recently hired a cleaner to clean the property and wash the linen. You also hire a gardener to mow the lawns.

You have business cards and brochures printed along with customer feedback forms.

You have provided a list of the costs incurred in setting up the property.

The property is not used for private purposes.

You are in full time employment.

You initially managed the holiday rental for the property as well as do promotion and maintenance activities and also update the internet. Now, you have a real estate agent managing the property.

You have a set bank account for your rental income and expenses and keep records of all property transactions.

The furniture and linen items are only used in the property.

You own one other investment property as sole owner. Related entities have an ownership interest in two other rental properties. These properties may be transformed into holiday accommodation if this property is successful. These properties are currently being managed with a real estate agent.

The property was painted inside and outside and needed modernisation and bringing it up to the required level to be a premium holiday rental and ahead of the competition.

Part of the painted timber fence was old, deteriorated and required modernisation. You purchased concrete mix to stabilise the fence posts.

The original letterbox was faulty and rusty and needed replacing.

The bedrooms were carpeted as there were no previous floor coverings. The lino flooring in the living areas is very worn and will be replaced.

The bathroom was updated as the original bathroom was tired and worn out. Bathroom tiles in the ensuites required updating due to cracks and age.

The fan motor in the heater was replaced as it was not working.

No gardens were present when the property was purchased. You purchased general garden items.

Existing door knobs and handles were a mismatch and had key locks with no keys.

The lights were updated to modernise the property. The original light fittings were many years old.

You purchased tools to help with the work. A drill was used for property maintenance.

You prepared a business plan.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5.

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

Under subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997), the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the income year.

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Business is defined in section 995-1 of the ITAA 1997 to be 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'.

The Commissioner's view on whether the letting of property amounts to the carrying on of a business is found in a number of places.

The Tax Office publication Rental properties 2016 states on page 5:

A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a rental property business, either alone or with the other co-owners. This is because of the limited scope of the rental property activities and the limited degree to which a co-owner actively participates in rental property activities.

Income tax ruling IT 2423 Withholding tax: whether rental income constitutes proceeds of business - permanent establishment - deduction for interest states:

A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations. An individual who derives income from the rent of one or two residential properties would not normally be thought of as carrying on a business. On the other hand if rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business.

Whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case, (Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 TC 159). Generally, it is easier for a company that derives income from the letting of property to show that it carries on a business than it is for an individual (paragraph 3 of Taxation Ruling IT 2423).

Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners quotes the legal case of Federal Commissioner of Taxation v McDonald (1987) 18 ATR 957; 87 ATC 4541, where Beaumont J said at ATR p 968; ATC p 4550:

The reference to "business" . . . indicates a "commercial enterprise as a going concern": see Hope v Bathurst City Council (1980) 144 CLR 1 at 8; 12 ATR 231 at 236 per Mason J. Purely domestic transactions are thus excluded from the definition: see Fletcher, op cit p 28. The "business" must be "carried on". This suggests some active occupation or profession: see IRC v The Marine Steam Turbine Co Ltd (1919) 12 TC 174 per Rowlatt J at 179.' . . . 'On the other hand, in the case of a private individual as distinct from a company, "it may well be that the mere receipt of rents from properties that he owns raises no presumption that he is carrying on a business." see American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue (1979) AC 676 per Lord Diplock at 684.

and at ATR page 969; ATC page 4552, where Beaumont J continued:

Their investment involved little, if any, active participation from either party ... This was not a case of the active joint participation by the parties in a business activity. Rather, it was a case of a renting out of premises without the provision of other services of the kind discussed in Wertman, supra. In my view, there was here a mere investment in property rather than a partnership in the properties or their profits.

The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Normally the receipt of income from the letting of property to a tenant(s) does not amount to the carrying on of a business (Wertman v. Minister of National Revenue (1964) 64 DTC 5158; Federal Commissioner of Taxation v. McDonald (1987) 15 FCR 172; 87 ATC 4541; 18 ATR 957 (McDonald's case); Cripps v. FC of T 99 ATC 2428 (Cripps' case); Case X48 90 ATC 384; (1990) 21 ATR 3389)

In Case G10 75 ATC 33 (Case G10), the taxpayer owned two properties of which six units were let as holiday flats for short term rental. The taxpayer, with assistance from his wife, managed and maintained the flats. Services included providing furniture, blankets, crockery, cutlery, pots and pans, hiring linen and laundering of blankets and bedspreads. The taxpayer also showed visiting inquirers over the premises, attended to the cleaning of the flats on a daily basis, mowing and trimming of lawns, and various other repairs and maintenance. The taxpayer's task in managing the flats was a seven day a week activity. The Board of Review held that the activity constituted the carrying on of a business.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? outlines some factors that indicate whether or not a business of primary production is being carried on. These factors equally apply to other types of businesses. No individual factor is determinative, but should be weighed up in conjunction with the other factors.

In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

● whether the activity has a significant commercial purpose or character

● whether the taxpayer has more than just an intention to engage in business

● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

● whether there is regularity and repetition of the activity

● whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

● whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

● the size, scale and permanency of the activity, and

● whether the activity is better described as a hobby, a form of recreation or sporting activity.

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' (Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case, and no one indicator will be decisive (Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922).

Applying the relevant indicators to your circumstances

Significant commercial purpose

The 'significant commercial purpose or character' indicator is closely linked to the other indicators and is a generalisation drawn from the interaction of the other indicators. It is particularly linked to the size and scale of activity, the repetition and regularity of activity and the profit indicators.

Your activity is the owning residential properties. Currently you own two investment residential properties as sole owner. You receive income from the properties. You initially managed one property, however this property as well as the other property is now managed by a real estate agent.

Intention of the taxpayer

The carrying on of a business is not a matter merely of intention; it is a matter of activity. It is appropriate to look at when the activities started and whether they add up to more than a mere intention to conduct a business.

You own two rental properties as a sole owner. The properties are rented at market rates. You do not currently actively manage the properties. Your intention is to receive a flow of income from the properties.

Prospect of profits

The taxpayer's involvement in a business activity should be motivated by wanting to make a tax profit and the taxpayer's activities should be conducted in a way that facilitates this. This will require examining whether objectively there is a real prospect of making such a profit from participating in the business of the taxpayer.

You intend to make a profit, however from the information provided, no estimated timeframe has been provided to show when a profit might be made. An increase in rent is how your income will increase.

Repetition and regularity

The taxpayer's activities should involve repetition and regularity and have an air of permanence about them. With regards to letting of properties, repetition and regularity may be measured by factors such as regularity of maintenance, collecting of rent, management and advertising of the properties, insurance, dealing with tenancy agreements and inspection reports.

You do not currently manage either of your properties. Although you initially managed one property, your involvement with the properties is minimal and it cannot be concluded that the level of repetition and regularity of your activity is a business.

Activities of the same kind and carried on in a similar manner to those of the ordinary trade in that line of business

If a taxpayer carries out their activity in a manner similar to other taxpayers in the industry, it is more likely that their activity amounts to the carrying on of a business. That is, the taxpayer's operations are of the same kind and carried on in the same way as those characteristic of ordinary trading in that particular line of business (IR Commissioners v. Livingston 11 TC 538).

Generally, where the property owners grant exclusive possession of the property to the residents the relationship between the two parties is one of tenant and landlord, and the activity is more likely to be passive investment rather than a business. Similarly, activities constituting the mere maintenance of an asset and the mere collection of income do not indicate the existence of a business.

Your activity is receiving rental income from your residential properties.

Organisation in a business-like manner, the keeping of books, records and the use of a system

The activities conducted by, or on behalf of the taxpayer, should be carried out in a systematic and organised manner. This will usually involve matters such as the keeping of appropriate business records by the taxpayer.

The size and scale of the activity

The business should be large enough to make it commercially viable. In Cripps' case, it was held that the renting of 14 two storey townhouses was not a business and in McDonald's case it was held that the letting of two units in different strata plans was also not a business.

Example 4 on page 5 of the Australian Taxation Office's Rental properties 2016 booklet involves taxpayers, who own 26 properties; spend approximately 25 hours per week each on managing the properties. You do not do the maintenance or management of your properties and the size and scale of your activities are not considered to be significant. You do not spend much time each week on your rental property activities.

Hobby or recreation

Your level of active involvement in relation to your properties are significantly less than those noted in Case G10. In comparison to the taxpayer in Case G10 their activity involved a significant amount of their time devoted to the holiday letting activity. In your case, you use the property for holiday rental and spend very little time on rental property activities. This is not considered to be a significant amount of time for a business activity.

Conclusion

The intention to make a profit is not, on its own, sufficient to establish that a business is being carried on. Where a business exists, there is usually a business plan of how the activities will be conducted.

As shown in the legal cases and the views of the Commissioner listed above, the indicators with the greatest weighting are the scale or volume of operations and the repetition and regularity of activities. The quantum of rental income derived does not affect the characterisation of the activity. Also the fact that you have an ABN does not mean you are carrying on a business for tax purposes.

We acknowledge you own two rental properties and receive income from them. This is not considered to be of a scale to take the activity beyond a passive rental income producing activity. After considering your specific circumstances and weighing up the relative business indicators, it is considered that you are not carrying on a rental property business for taxation purposes. Your activities are not conducted on a sufficient scale to be considered to be a business.

Allowable deductions

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.

The Commissioner's view on whether deductions are allowable 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) are outlined in Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities.

In Steeles case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. 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.

While Steele's case deals with the issue of interest, the principles can be applied to other types of holding expenditure such as rates and utilities.

In your case you have purchased property and began work on it soon after purchase. The property was rented approximately eight months after purchase.

Although rental income from the property was not be derived initially, it is considered that there is sufficient connection between your rates and utility expenses to the earning of your assessable income. It is considered that the requirements as outlined above are met.

Consequently a deduction is allowable for the rates and utility expenses incurred for the property before the property was rented under section 8-1 of the ITAA 1997.

Set up costs

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises used for income producing purposes, to the extent that the expenditure is not capital in nature.

Taxation Ruling TR 97/23 Income tax: deductions for repairs explains the circumstances in which deductions for repairs are allowable.

TR 97/23 indicates that expenditure for repairs to property is of a capital nature and not deductible 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. 

Repair costs are deductible where they are incurred during the period the property is held for income producing purposes and are attributable either to damage that occurs during your income producing use of the property or to defects that emerge suddenly during that time.

In your case, the repairs and other work to the property were carried out before the property was available for rent. Such works is regarded as initial repairs and are regarded as capital in nature. Therefore no immediate deduction is allowed for such repairs and your set up costs.

However as outlined below, a capital works or depreciation deduction may be allowed for some items.

Capital works

Division 43 of the ITAA 1997 provides a deduction for capital works. Capital works includes buildings and structural improvements, and also extensions, alterations or improvements to buildings and structural improvements where a residential property is used for income producing purposes.

Subsection 43-25(1) of the ITAA 1997 provides that the rate of deduction for capital works which began after 26 February 1992 for a residential rental property is 2.5%. However, a deduction cannot be made prior to the completion of the capital works (section 43-30 of the ITAA 1997).

The following improvements to your property are regarded as capital works:

● Bathroom improvements and shower screens

● Tiles

● Tapware, door knobs, handles

● Letterbox

● Fence

● Deck

● Lights

● Painting

● Other items fixed to the building

A pro-rata 2.5% capital works deduction is allowed in the 201X-1Y financial year after the property is rented and used for income producing purposes.

Depreciating assets

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 following items are regarded as depreciating assets for Division 40 of the ITAA 1997 purposes:

● Furniture

● Blinds

● Linen

● Tools

● Heater

● carpet

A deduction for the above depreciating assets decline in value is allowable where they are used for income producing purposes. For details on how to calculate the allowable depreciation deduction, please refer to the Australian Tax Office's Guide to depreciating assets which is available on the website www.ato.gov.au.

Other items

Other items such as a guest book, stationery, business cards, pegs and glue are not regarded as depreciating assets or capital works, however the cost of these items are deductible under section 8-1 of the ITAA 1997 where they are being used solely for your rental property.

Plants and gardening expenses

General garden maintenance is an allowable deduction under section 8-1 of the ITAA 1997 where, for example, you pay a tradesman to mow lawns or maintain garden beds for a property that is rented or available for rent. However, landscaping is considered to be an improvement and capital in nature and therefore not an allowable deduction.

In your case, you incurred expenses for general garden maintenance before the property was rented. Such costs are capital in nature and not an allowable deduction under section 8-1 of the ITAA 1997 or section 25-10 of the ITAA 1997.

The cost of installing gardens is not regarded as capital works or depreciating assets. No deduction is therefore allowed for these costs.

These expenses can be included in the cost base of the property for the purposes of calculating any capital gain or loss on the disposal of the property.

Other information

Where you have a net rental loss in an income year, this can be used to reduce your other ordinary assessable income such as salary and wages.