Edited version of private advice

Authorisation Number: 1051994344401

Date of advice: 11 July 2022

Ruling

Subject: Rental property expenses - mortgage discharge fees

Question

Will the early termination fee paid by you in the 20XX income year, to discharge the mortgage over your rental property, be included in the cost base of your rental property which was sold in the 20XX income year?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Person A and Person B (you) purchased a property.

The property was purchased as a rental property and rented out from the date of purchase.

Many years after the purchase of the property Person A became unfit for work due to a medical condition.

Person A underwent medical treatment which resulted in them being unfit for work for an extended period of time.

A short time later a contract for the sale of the property was signed and the property was sold.

Settlement occurred on the property in the income year after the contract for the sale of the property was signed.

A loan discharge fee was charged by your loan provider and was deducted from the sale proceeds of the property on settlement.

Person A underwent further medical treatment after the sale of the property and remains unfit for work.

Reasons for decision

Deductions

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, or relate to the earning of exempt income.

The timing of an expense is an important issue since it governs the tax year when a deduction can be claimed.

In your case the early termination fee was incurred in the 20XX income year.

Capital gains tax event

Section 102-20 of the ITAA 1997 states you make a capital gain or capital loss if a CGT event happens to a CGT asset.

Under section 104-10 of the ITAA 1997 CGT event A1 happens if you dispose of your ownership interest in a CGT asset.

You are taken to have disposed of a CGT asset if there is a change of ownership of the CGT asset from you to another entity.

The time of the CGT event is when you enter into the contract for the disposal or if there is no contract, when the change of ownership occurs.

Subsection 104-10 of the ITAA 1997 provides an example of the timing of the CGT event and when to record the capital gain made:

In June 1999 you enter into a contract to sell land. The contract is settled in October 1999. You make a capital gain of $50,000.

The gain is made in the 1998-99 income year (the year you entered into the contract) and not the 1999-2000 income year (the year that settlement takes place).

In your case the capital gains tax event occurred when you signed the contract to sell the rental property in the 20XX income year.

Cost base

A capital gain is made on the disposal of a CGT asset when the proceeds received from the sale are more than the cost base of the asset.

Accordingly, to determine the extent of any assessable gain, it is necessary to determine the cost base of the asset.

Section 110-25 of the ITAA 1997 provides that the cost base of a CGT asset has five elements. These include the initial cost of the asset, as well as certain other costs associated with acquiring, holding and disposing of the asset. The five elements are:

First element

The money paid, or required to be paid, in respect of acquiring the CGT asset and/or the market value of any other property given, or required to be given, in respect of acquiring the asset.

Second element

Incidental costs of acquiring the CGT asset or costs that are incurred in relation to the CGT event that happens to the asset, including its disposal. These costs include stamp duty, legal fees, agent's commission and fees paid for professional services.

Third element

Non-capital costs of owning the CGT asset can include interest on money borrowed to acquire the asset, costs of maintaining, repairing or insuring the asset, rates or land tax, interest on money you borrowed to refinance the asset and interest on money you borrowed to finance the capital expenditure you incurred to increase the assets value.

Note:

• these costs can only be added to the cost base of an asset you acquired after 20 August 19XX; and
• this element does not apply in working out a capital loss.

Fourth Element

Capital expenditure incurred to increase the CGT asset's value, and which is reflected in the state or nature of the asset at the time of the CGT event.

Fifth element

Capital expenditure incurred to establish, preserve or defend the title to the CGT asset, or a right over the asset.

Incidental costs of the cost base

Incidental costs of the second element of the cost base of a CGT asset cited in subsection 110-25(3) can only be included in the second element of the cost base and reduced cost base of a CGT asset if they are incurred by the owner of the asset to acquire the asset or if they relate to a CGT event that later happens to the asset.

Section 110-35 of the ITAA 1997 sets out a number of incidental costs that the taxpayer might have incurred to acquire a CGT asset or that relate to a CGT event.

Subsection 110-35(9) states that borrowing expenses such as loan application fees and mortgage discharge fees are included in these incidental costs.

In your case the early termination fee incurred by you when you paid off your rental property loan early is regarded as an incidental cost of the CGT asset under subsection 110-25(3) and subsection 110-35(9) of the ITAA 1997.

Deductible expenditure

Expenditure incurred in borrowing money or in the discharge of a mortgage is generally non-deductible capital expenditure.

However, section 25-30 of the ITAA 1997 allows a deduction for expenditure incurred to discharge a mortgage where the mortgage is given by the taxpayer as security for the repayment of money borrowed by the taxpayer and used by the taxpayer for the purpose of producing assessable income.

Paragraph 8 of Taxation Ruling 2019/2 Income tax: whether penalty interest is deductible (TR 2019/2) states that:

'penalty interest incurred to discharge a mortgage is deductible under section 25-30 to the extent that the loan moneys were used for producing assessable income. Unlike section 8-1, deductibility is not affected whether the expenditure is capital or revenue in nature.'

Paragraph 16 and 17 of TR 2019/2 provides an example where Sally discharges the mortgage of her rental property early and is charged penalty interest:

'Sally sells her rental property, repays the loan to discharge the mortgage over the property and incurs penalty interest.

The penalty interest is a necessary incident of the sale of the property. A payment so connected to the realisation of a capital asset will be on capital account and not deductible under section 8-1. As the penalty interest is not a cost of borrowing incurred in establishing the loan, it is not deductible under section 25-25. It is deductible under section 25-30 as an expense of discharging the mortgage.'

Paragraph 29 of TR 2019/2 also states that

'Penalty interest incurred to discharge a mortgage is deductible under section 25-30 to the extent the loan moneys or property are used for producing assessable income. No deduction is available for payments of principal or interest. Unlike section 8-1, deductibility is not affected by whether the expenditure is capital or revenue in nature.'

In your case the early termination fee incurred by you when you paid off your rental property loan early is regarded as deductible expenditure under section 25-30 of the ITAA 1997 and highlighted in Taxation Ruling 2019/2 and can be included as a deduction in your tax return.

Deductible expenditure not included in cost base

Section 110-45 of the ITAA 1997 is to do with assets acquired after 7.30 pm on 13 May 1997. Subsection 110-45(1) states this section prevents some expenditure from forming part of the cost base, or of an element of the cost base, of a CGT asset acquired after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997.

Subsection 110-45(1B) of the ITAA 1997 specifically states that deductible expenditure is excluded from the second and third elements of the cost base to the extent that you have deducted or can deduct it.

Section 110-55 of the ITAA 1997 also excludes from the reduced cost base of the asset an amount that you could have deducted for a CGT asset had you used it wholly for the purpose of producing assessable income.

Para 33 of TR 2019/2 also advises that penalty interest is excluded from the cost base or reduced cost base to the extent it is deductible.

In addition, Taxation Determination TD 2005/47 Income tax: what do the words 'can deduct' mean in the context of those provisions in Division 110 of the Income Tax Assessment Act 1997 which reduce the cost base or reduced cost base of a CGT asset by amounts you 'have deducted or can deduct', and is there a fixed point in time when this must be determined? specifies that, where an amount that could have been deducted was not deducted, a taxpayer cannot include the amount (that could have been deducted) in the cost base of a CGT asset if the period for amending the income tax return to which the deduction relates has not expired.

In your case the early termination fee incurred by you when you paid off your rental property loan early is deductible expenditure under section 25-30 of the ITAA 1997 and therefore excluded from the second and third elements of the cost base of your rental property under section 110-45(1B) and section 110-55 of the ITAA 1997 and advised in paragraph 33 of TR 2019/2.

Your argument

Paragraph 10 of TR 2019/2 advised that penalty interest that is an incidental cost incurred in relation to a CGT event or to acquire a CGT asset is included in the cost base or reduced cost base of the CGT asset.

Paragraph 18, 19 and 20 of TR 2019/2 provides Example 3 where Alex discharges the mortgage on a holiday home early and is charged penalty interest:

'Alex obtained an unsecured loan to purchase a beach house to use solely as a holiday house for his family. Alex and his family move interstate for work. Alex sells the beach house, immediately repays the loan early and incurs penalty interest.

Penalty interest is incurred in connection with selling a private-use asset; the expenditure is private in nature and not deductible under section 8-1. As the loan is unsecured, section 25-30 cannot apply.

The penalty interest is an incidental cost which relates to the sale of the beach house and can be included in the cost base under subsection 110-35(9) or the reduced cost base under subsection 110-55(2). However, if Alex did not repay the loan immediately it would be difficult to demonstrate that the penalty interest is an incidental cost.'

Application to your circumstances

Deductible expenditure

In Example 3 of TR 2019/2 the CGT asset was solely a private-use asset meaning no income or revenue was received by the owner for the use of the holiday home.

As the holiday home was solely a private-use asset the penalty interest incurred by the owner was not a deductible expenditure, it was a capital expenditure.

As the penalty interest was not a deductible expenditure, but a capital expenditure, it could be added to the cost base of the asset.

Paragraph 10 and Example 3 of TR 2019/2 does not apply to you and is not the same as your situation.

Your CGT asset was a rental property, and you were receiving assessable rental income from your rental property.

As you were receiving assessable rental income from the rental property the early termination fee incurred by you on the early termination of the loan can be deducted under section 25-30 of the ITAA 1997.

As stated in subsection 110-45(1B) of the ITAA 1997 deductible expenditure is excluded from the second and third elements of the cost base to the extent that you have deducted or can deduct it.

As the deductible expenditure costs are excluded from the cost base of the CGT asset the early termination fee you incurred cannot be included in the cost base of your rental property.

Consequently, you are not able include the early termination fee you incurred in the calculation of the capital gain you made on the sale of your rental property.

Timing of your deductible expenditure and CGT event

Furthermore, as stated in section 104-10 of the ITAA 1997 if there is a contract of sale, the CGT event happens when you enter into the contract. For example, if you sell a house, the CGT event happens on the date of the contract, not when you settle.

You signed the contract to sell the rental property in the 20XX income year.

As you signed the contract for the sale of the rental property in the 20XX income year you need to record the capital gain made in the 20XX income year.

When settlement occurred on the rental property an early termination fee was deducted from the sale proceeds by the lender.

The early termination fee is a deductible expenditure related to your rental property and was incurred by you in the in the 20XX income year.

As the early termination fee was incurred in the 20XX income year it has to be deducted in the year it was incurred.

Conclusion

Incidental costs are excluded from the cost base of the CGT asset if they can be or have been deducted. As the early termination fee is a deductible expense it is excluded from the cost base of the rental property.

Deductions need to be claimed in the year in which they were incurred. As your rental property was sold in the 20XX income year and the early termination fee was incurred in the 20XX income year, the early termination fee cannot be included in the cost base of the rental property.

Further information

You have asked us to consider paragraph 3 in the preamble of TR 2019/2 which states the following:

'Further, if we think that the ruling disadvantages you, we may apply the law in a way that is more favourable to you.'

We have considered the preamble and we have applied the law to you in the way set out in TR 2019/2 and you have not paid any more tax or penalties or interest in respect of the matters covered by TR 2019/2. We are advising you on how to correctly apply TR 2019/2 to your situation and you are claiming the deductions available - this is not unfair to you nor disadvantageous to you.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-30

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 section 110-45

Income Tax Assessment Act 1997 section 110-55