Edited version of private advice

Authorisation Number: 1052198509027

Date of advice: 1 December 2023

Ruling

Subject: Deductions - rental expenses

Question

Is the interest on the mortgage and the depreciation deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), for the period when your property is required to be left empty for 12 months, as specified by a leasing policy under a Company Title?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You own shares over a Unit (the Unit) under Company Title (the Company).

The shares give you exclusive beneficial ownership in the Unit.

When you obtained the shares over the Unit, the Company provided you with the 'Articles of Association' of the Company, dated from XX 20XX.

When you obtained the shares over the Unit, the Company also provided you with a Leasing Policy, dated from XX 20XX.

You were the main resident of the Unit for X years.

You moved out of the Unit when you bought a house for your growing family.

When you moved into your house, you rented the Unit in order to produce assessable income.

The Leasing Policy you were provided, details the conditions and limited rights upon which you, as a shareholder in the Company, can lease a unit to another person/tenant.

Clause XX of the Leasing Policy under the Company Articles states that:

"The maximum period for which a shareholder may lease their apartment is 36 months, following which a further qualifying period of full time residence for 12 months will be required, except where the tenant is a long term tenant i.e has been resident for 3 years, and both the tenant and the shareholder wish to extend the lease."

Clause XX of the Leasing Policy explains that:

"A Qualifying Shareholder may apply to the Board to have any of these conditions waived."

After XX years sub-leasing the Unit to a tenant, you, as a shareholder, are required to move back into the Unit or leave the Unit vacant for XX months.

You would prefer to continue to sub-lease the Unit, instead of moving back in or leaving the Unit vacant.

You have not provided the board of directors with details of your intentions; nor applied under Clause XX of the Leasing Policy for the board to waive the conditions of the Leasing Policy.

You sought legal advice to understand if the Leasing Policy adopted by the board of directors of the Company is legal and enforceable.

Your legal advice indicated the Leasing Policy is most likely legal and enforceable.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-25

Income Tax Assessment Act 1997 section 40-25

Reasons for decision

Detailed reasoning

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.

Rental expenses are deductible to the extent that they are incurred for the purpose of producing rental income.

Expenses may be deductible for periods when the property is not rented out, providing the property is genuinely available for rent - that is:

•         The property is advertised in ways which give it broad exposure to potential tenants, and

•         Having regard to all the circumstances, tenants are reasonably likely to rent it.

Interest

Interest payments are generally deductible on money borrowed to purchase, construct or renovate a business asset or an income producing property (e.g. a rental). This also includes investments in other income-producing assets (e.g. shares or trust units).

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income.

The character interest on a loan is generally ascertained by reference to the purpose of the loan (Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 (Fletcher's Case)) and the use to which the loan is put (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153 (Munro's Case)). Therefore, if a loan is used to purchase property from which income is to be derived, the interest paid on the loan is generally deductible.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. However, where a loan relates to private purposes, no deduction is allowed. Paragraph 3(f) explains that interest on borrowing will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

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 explains that the use to which funds are put are useful in determining the deductibility of interest. A statutory issue for consideration, is whether the interest outgoing was incurred in the course of the income producing activity. TR 2004/4 states that continuing efforts are required to be undertaken in the pursuit of assessable income. If a venture becomes truly dormant and the holding of the asset is passive, relevant interest will not be deductible even if there is an intention to revive that venture sometime in the future.

Borrowing expenses

Section 25-25 of the ITAA 1997 considers that a deduction is only allowed in an income year in which the borrowed money is used by the taxpayer for the purpose of producing assessable income.

If, in a particular year, the borrowed money is not used for the purpose of producing assessable income, the taxpayer is not entitled to a deduction in that year for the borrowing expenses. This may happen, for example, where the borrowed money is used to purchase a property which is used for private purposes (e.g. as the taxpayer's residence) one year and is used to earn income (e.g. by renting it out) in another year.

Subsection 25-25(2) of the ITAA 1997 explains that you can deduct expenditure you incur if you use the borrowed money during that income year solely for the purpose of producing assessable income.

Depreciation

A deduction for the decline in value of depreciating assets is available under Division 40 of the ITAA 1997. Specifically, a deduction is available for the decline in value of a depreciating asset that is held by you to produce assessable income under section 40-25 of the ITAA.

Subjective purpose, motive, or intention

In determining the deductibility of interest incurred by individuals, appropriate tests are the purpose of the borrowing or the use and application of the borrowed funds. If no income is derived from the transaction to which the interest expense relates, and there is no connection to gain or produce assessable income, then the purpose of the borrowing may be relevant to the occasion of the outgoing.

Where funds are borrowed to facilitate the purchase of a residential property for private or family use, the character of the interest expenditure will be private or domestic in nature when the property is not available, or genuinely available for rent.

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevant of subjective purpose, motive, or intention in determining the deductibility of losses and outgoings considers various issues in determining the deductibility of losses and outgoings. This TR also relates these principles to the usual kind of negatively geared investments.

TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure. If the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is deductible.

On the basis of the 'use' or 'purpose' test, the interest and depreciation costs incurred on the loan to purchase a home are not deductible while the property is not used to produce assessable income.

Application to your circumstances

In your case, the occasion of the outgoing in relation to the money borrowed, was to obtain a mortgage for the purchasing of shares in a company. The shares give you beneficial ownership in a Unit, that was obtained and used as your main residence for the initial X-years of ownership.

When you purchased a new residential home, you sub-leased your Unit. After X years sub-leasing the Unit, you are required to move back into the Unit or leave the Unit vacant for XX months. As a result, the right to occupy the Unit has been returned to you in accordance with the Leasing Policy.

Your property is not genuinely available for rent for X year in every X years. For the year that your property is not able to produce assessable income, the interest expenses and depreciation are not deductible. The Unit must be rented or genuinely available for rent in order to produce assessable income to be eligible to claim a deduction for expenses under section 8-1 of the ITAA 1997.