Edited version of private advice

Authorisation Number: 1052134891688

Date of advice: 29 June 2023

Ruling

Subject: Deductibility of rental property expenses

Question 1

Can you claim a deduction for the interest charged on your building loan for a residential investment property you intend to rent out upon completion of construction in the year/s the interest is incurred?

Answer

No.

Question 2

Can I claim a deduction for council rates, water rates, emergency services levy and insurance during the building period for your residential property you intend to rent out upon completion of construction in the year/s the expenses are incurred?

Answer

No.

This private ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

On X September 20XX you entered into separate land and build contracts for a property.

The land purchase was settled on X February 20XX and paid by funds held.

The building contract costing $X is to be partially financed by a principal and interest (P&l) variable rate loan from a bank for $X.

You need to make staged payments the builder up until completion and handover.

The build has commenced with footings now laid.

Once the build is completed and handover occurs you intend to rent out the property as a residential investment property.

The builder currently expects to complete the build by May 20XX, although naturally this may be delayed.

You expect to make the next payment in May or June 20XX and will partially draw down the loan from the bank and start incurring interest charged from then on, building up as further payment instillments are made.

The property title and bank loan are in your name only.

You have incurred interest expenses on your building loan during the construction period of your residential property.

You have also incurred expenses for council rates, water rates, emergency services levy and insurance during the construction period of your residential property.

You are not in the business of renting properties.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 51(1)

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are not entitled to claim deductions for the interest and other expenses because these expenses all occur at a point too soon.

Detailed reasoning

Expenditure will generally be deductible under subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) if its essential character is that of expenditure that has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income, provided that the expenditure is not of a capital, private or domestic nature.

Expenditure incurred prior to assessable income

The Tax Office's view on the application of subsection 51(1) of ITAA 1936 to the deductibility of rental property expenses is contained 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 (TR 2004/4). Of particular relevance to your circumstances are paragraphs 27, 28 and 31 and the High Court case known as Steele's case, which ruled on how subsection 51(1) applies to the deductibility of interest expenses but which can also be applied to related expenses.

Steele's case

27. The rejection of the Full Federal Court's finding of capital did not dispose of the matter for the High Court. It revitalised the relevance of the earlier finding of the Administrative Appeals Tribunal that Mrs Steele should be denied a deduction in respect of the interest outgoings (in excess of agistment income) substantially on the ground that the first limb of subsection 51(1) was not satisfied.

28. In Steele's case (99 ATC 4242 at 4251; (1999) 41 ATR 139 at 151), the majority embraced the proposition that expenditure will be 'incurred in gaining or producing the assessable income' (that is, come within the first limb of subsection 51(1)) if it is 'incidental and relevant' to the gaining or producing of that income. In the case of Mrs Steele, the relevant assessable income was not expected until well into the future, and the question arose as to whether, in all the circumstances, the interest expenditure was indeed both 'incidental and relevant'.

31. It is well accepted that expenditure can satisfy the positive limbs of subsection 51(1) even though it is incurred in a period prior to any expected resultant income.

Even so, the majority in Steele acknowledged that those limbs will not be satisfied if that expenditure is 'too soon', 'preliminary' or a 'prelude' (see paragraph 30):

• An outgoing may be 'too soon' in the sense that a significant delay between the incurring of an outgoing and the actual or projected receipt of income may be relevant in determining whether expenditure is deductible; and
• An outgoing may be 'too soon' in the sense that the advantage conferred by the expenditure is necessary for, but not to be found 'in', the regular income earning activities ('functionally too soon'). Such a situation can arise even in the absence of the above mentioned 'significant delay'.

Application to your circumstances

You have incurred interest loan expenses as well as expenses for council rates, water rates, emergency services levy and insurance, during the construction period of your residential property which, upon completion, you will make available for rent.

It is acknowledged that your intention is a profit making one and accepted that the property will, at some point in the future, produce assessable income. However, all the expenses are being incurred during the construction period of the property. As such, they are incurred at a time when the property is not in a fit state to be made available for rent and, hence, produce assessable income. The expenses cannot be described being incurred in gaining or producing of that income because they occur at a point too soon to do so. As in Steele's case, the relevant assessable income is not expected until well into the future. In your case, not until the projected completion date of May 20XX, at the earliest.

Therefore, you are not entitled to claim a deduction for the interest expenses or for the expenses for council rates, water rates, emergency services levy and insurance, under subsection 51(1) of the ITAA 1936.

Note that all references to subsection 51(1) ITAA 1936 should be taken as including a reference to section 8-1 Income Tax Assessment Act 1997.