Investment Property Tax

The investment property outgoings which are allowable deductions must be shared between owners according to the legal interest of each owner. For example, Thomas and Magnolia are tenant-in-common owners of an investment property with a 40% / 60% legal interest respectively.

Thomas will be entitled to a 40% share in the interest expense deduction and Magnolia will be entitled to 60%. In this way, Thomas or Magnolia may not hoard the entire interest deduction for themselves. Joint tenants are treated the same as tenants in common except that the legal interest of each owner will be split evenly.

If Thomas and Magnolia were joint tenants both would be entitled to a 50% share of the investment property interest deductions.

Interest may be limited to the amount of return on investment. For example, if a rental property earns $50,000 in annual rental income and annual interest outgoings are $70,000, the $20,000 excess may be subject to further scrutiny before a deduction is allowable for that amount.

A taxpayer is not permitted to claim a deduction for interest on vacant land or land without a permanent structure ready for habitation e.g. a building under construction.

For example, David purchases a vacant block of land for $500,000. He obtained finance from a lending institution to cover the entire purchase price. He intends to construct on the land and rent out the property. In this example, until construction is completed and the property is rented or available for rent, the interest outgoings on the loan to purchase the vacant land will not be deductible.

Note that interest on any part of a loan financing the cost of construction is generally deductible if the intention is for the property to be rented. For example, assume David has a separate loan for $300,000 to cover construction costs. The interest outgoings on that loan would be deductible.

The vacant land rules do not apply where the taxpayer that owns the vacant land is carrying on a business of property development or primary production or where the taxpayer is a company.

Generally, tax deductions related to the cost of holding vacant land will not be denied if there is a substantial and permanent structure on the land that is in use or available for use, and the structure has to be independent of and not incidental to the purpose of any other structure or proposed structure on the land.

In this context, a substantial structure must be significant in size, value or some other criteria of importance in the context of the property, and to be permanent, the structure needs to be fixed and enduring (eg a house). In addition, structures that have the purpose of increasing utility of another structure are not considered independent. For example, the ATO notes that while fencing, garages, or sheds may be considered substantial and permanent, they do not have a purpose independent of the residence.

Additionally, to be able to claim a deduction, any substantial and permanent structure must be in use or available for use. According to the ATO, whether from a residential or commercial perspective, this means that the premises are capable and lawfully able to be occupied. For example, in situations where some residential premises on the land has been deemed by the local council or another relevant body/qualified professional of being unsafe to occupy, then any deductions would be denied from that point onwards as the structure was “not available for use”.

However, if an owner of a vacant lot constructs or substantially renovates existing residential premises on the lot, the structure will be disregarded as a substantial and permanent structure unless it can be lawfully occupied and is leased, hired, or licensed (or available for lease, hire or licence). In other words, where an individual purchases vacant land and then builds a residence on the land, they can only deduct holding costs from the date the residence is both lawfully able to be occupied (ie occupancy certificate issued) and is available for lease (ie listed with an agent).

These two conditions (ie lawfully able to be occupied and available for lease) will apply throughout an individual’s entire ownership period of the land where a new premises is constructed or an existing premises is substantially renovated. This means that if the owner decides to stop leasing the premises for a period of time for any reason, the structure would be disregarded, and the land will be considered to be vacant, and deductions may be denied.

Further complications exist where an individual purchases a vacant block on multiple titles and builds residential premises on only one of the titled blocks, or where a vacant block is purchased and then subdivided and a residence built on only one of the subdivided blocks. Taxpayers should also be careful when selling previously vacant land that they have constructed premises on (or if they have substantially renovated the premises) to avoid unintended tax consequences.

A linked or split loan facility involves at least two loans or sub-accounts. One sub-account could relate to a private purpose and another could relate to an income-producing purpose. Under these arrangements, the repayments can be allocated to the private account and the unpaid interest on the income-producing account can be capitalised to create an ‘interest on interest’ effect. This results in a favourable tax outcome for the taxpayer as the amount of deductible interest is maximised and the amount of non deductible interest is minimised. Note that the ATO has suggested that such arrangements may be in breach of the anti-avoidance rules. Further advice should be sought before entering into this type of arrangement.

Interest incurred will only be deductible during the periods in which the financed asset is an income-producing asset. The asset will only be income-producing where its use enables the derivation of assessable income i.e. when it is rented. Note that an asset will still be considered income-producing where the property is not currently being rented but is openly available for rent. The taxpayer must be able to demonstrate genuine efforts to find a tenant. For example, by advertising the property.

There may be circumstances where an alternative party obtains finance and on-lends those funds. For example, an individual beneficiary of a trust may obtain finance and on-lend that to the family trust which was unable to obtain finance itself. In order for the interest to be deductible to the individual, it may be necessary for the individual to charge the trust interest on the on-lent funds, preferably at a rate that at least matches the rate charged by the financier to the borrower. This will limit the risk of part or all of the interest outgoings not being deductible.

The borrowing of money to purchase an asset which is not income producing e.g. a primary residence, is not deductible. A complication that commonly arises in practice is where an investment property is used for private purposes for periods of time.

For example, take David who purchased an investment property on 1 July 2023 and rented it out until 30 June 2024. On 1 July 2024 he moves into the house and uses it as his personal residence. In this instance, the borrowed funds were initially applied to purchase an income-producing asset.

However, from the 1 July 2024, the asset ceased to be income-producing. In these circumstances, an ongoing daily assessment needs to be made regarding the use of the property. Interest which is incurred during the period of time that the property is rented will be deductible. Interest incurred during the period of time that the property is used as a primary residence is not deductible. For David, interest incurred from 1 July 2023 – 30 June 2014 is deductible. Interest incurred from 1 July 2024 onwards is not deductible.

Interest may also be partially deductible where only part of the property is used for an income-producing purpose and the other part is not. For example, Brooke rents out the ground level of her house for the entire income year via short stay accommodation and lives on the second level. In this instance, the area of the property that is used for an income-producing purpose will determine the deductible percentage of the property. The deductible percentage should be multiplied by the interest outgoings with the calculated amount being the amount of deductible interest. In this example, the area of the property used for renting is 50% of the total property area. Therefore, Brooke may deduct 50% of the interest outgoings on the investment property loan.

There are limitations on claiming a deduction on prepaid interest. The prepayment rules restrict the bringing forward of deductions via prepayments. Note that an eligible small business can claim a deduction on interest outgoings brought forward no more than 12 months.

The same interest deductibility analysis above generally applies equally to investment properties acquired by companies and trusts. However, note a couple of things. The vacant land rules discussed above do not apply to companies. Further, any tax loss resulting from high interest deductions will be trapped in the trust or company and may not be of benefit to the company or trust until future income years whereby stored up tax losses can be applied as a deduction against assessable income (assuming the relevant company or trust loss rules are satisfied).

Generally, interest which is not deductible may still be added to the CGT cost base of the investment property. This will have the effect of reducing any capital gain on the sale of the investment property.

However, because of delay in receiving the tax benefit (the tax benefit is essentially deferred until the point of sale) and the fact that the gain is likely to be reduced by the 50% CGT discount (not available to companies or properties held less than 12-months), it is generally preferrable to have interest being deductible rather than added to the cost base of the property.

The ATO in IT 2167 contemplate the assessability of income and the deductibility of outgoings under a number of different informal rent arrangements. The below sub-headings provide a quick snapshot of the contents of that IT.

Where there is an arms length letting of an identified part of a residence (e.g. a bedroom, with access to generally living areas).

If the letting arrangement has a commercial nature, rent payments and contributions related to variable or running costs (to the extent those contributions represent a reward for the taxpayer letting out part of their residence) will generally be assessable income.

The taxpayer will be entitled to a deduction for eligible outgoings (that have a deductible character) in respect of the floor area of the residence that is let (compared with total floor area, including garage and outdoor areas), plus a reasonable figure for access to general living areas.

If the arrangement has sufficient non-commercial features (for example, if the taxpayer agrees to charge the occupant below commercial rates as a matter of goodwill), the arrangement may fall entirely outside of the tax net (meaning the taxpayer will not need to account for income nor be permitted to claim deductions).

Letting of property to relatives

If the letting arrangement has a commercial nature, the arrangement will be treated in the same way as a normal commercial arrangement. That is, rent payments and contributions will generally be assessable. Similarly, the owner will be entitled to a deduction for eligible losses and outgoings incurred. Again, if only part of the property is let, then only portion of eligible outgoings/losses will be deductible.

However, if the arrangement has a non-commercial nature, for example, where the property is let to relatives at less than commercial rates, then tax outcomes would potentially be different. In this situation, the rent payment and/or contribution under such an arrangement would be assessable to the extent it represents a reward to the taxpayer for the provision of the property. Separately, the deductibility of losses/outgoings depends on the purpose of the taxpayer in acquiring the property and letting it out. If the primary purpose was to produce assessable income, then a deduction would be allowable to the extent the taxpayer carries that purpose. Conversely, if the primary purpose is private or domestic one, then a deduction is not allowable to the extent the taxpayer carries that purpose.

It is possible for a taxpayer to possess mixed purposes (e.g. one purpose to produce assessable income and another purposes which is not related to the production of assessable income). To illustrate, in the case of Kowal v FCT, the court determined that the taxpayer held two objectives in renting a property out to his mother. The first was to provide his mother with good accommodation at a moderate cost (a 20% purpose) and the second was to generate assessable income (a 80% purpose). The court thus decided to allow a deduction for the portion of overall purpose that reflected the intention to generate assessable income. Consequently, the taxpayer was allowed a claim a deduction for 80% of eligible outgoings.

If rent charged is below market rates, the working rule is that any income tax deductions for losses and outgoings incurred in connection with a rented property will be allowed up to the amount of rent received.

Payment by family members of an amount for board or lodging

Generally, payments under this type of arrangement will not be considered income according to ordinary concepts. Accordingly, outgoings/losses will not be deductible.

Occupancy of part of a residence on the basis of the occupants sharing household costs such as food, electricity and cleaning etc.

If the letting arrangement involves the occupant paying a fee that is designed merely to cover their share of costs – for example, meals or electricity – the taxpayer will typically not be assessed on that fee (and consequently, not will they will be entitled to claim deductions in respect of that arrangement). That is because, overall, the taxpayer is not conferred with any benefit or reward under the arrangement.

The fee may be assessable if the amount received exceeds the occupants share of costs and is likely to result in the owner achieving a surplus position that is not negligible. If the fee is assessable, the taxpayers ability to claim deductions for losses/outgoings would again depend on the taxpayer having the requisite dominant purpose of producing assessable income as opposed to facilitating an objective which lacked that purpose.

Taxpayers are cautioned against dressing up ordinary tenancy arrangements in the way represented under this sub-heading, and there is presumption that the payments made by the occupants will contain an element of reward to the taxpayer for the occupancy of the residence if the taxpayer were not a party to the sharing arrangements or if the occupants made a fixed contribution to the taxpayer for household costs.

Letting of a holiday home etc. for part of the income year

If there is a letting arrangement where the property is let out for a short period on a non-commercial basis, e.g. to family members for a minimal fee – then the fee paid will generally not be assessable nor will the owner be entitled to claim deductions for losses/outgoings connected to that arrangement.

However, if the letting arrangement occurs on a commercial basis, the fee paid will generally be assessable to the taxpayer. The taxpayer will also generally be entitled to deductions for losses/outgoings under the arrangement according to the proportion of the property that was available to be used (by percentage of floor area) and according to the portion of the income year the property was let.

Note that the taxpayer may also be entitled to eligible deductions for portions of the income year the property was available to be let (but not actually let). That requires the owner to demonstrate active and bona fide efforts to let the property and not impose unreasonable rental conditions that make it unlikely for the property to become let. For example:

• limited efforts to broadly advertise the property as available
• the property is located in a difficult to access location
• unreasonable or stringent conditions imposed on the stay
• applications to let are refused without adequate reason

The ATO in a number of private rulings contemplate the assessability of income and the deductibility of outgoings under a number of different informal rent arrangements. We have analysed a few of those private rulings and provide a brief summary of the facts and outcomes below.

Keep in mind that private rulings do not establish binding principles. They are simply provided here to illustrate how certain arrangements have been ruled on.

PR – 1052258644812

The taxpayer owned a residential property used as their main residence. Two individuals commenced living in the residence, initially through an arrangement with a third-party homestay organisation and then subsequently through a private arrangement made directly with the taxpayer. The fee charged was designed to cover the utility bills and three meals a day for the occupants.

Here, the ATO was satisfied that this arrangement was a domestic arrangement with no benefit/reward conferred on the taxpayer. That is because the taxpayer would not expect to have any surplus money left over after using the fee to cover the costs of food and utilities for the occupants.

Thus, section 6-5 of the ITAA (to make the fee assessable) was ruled not apply. On the basis that the fee was not assessable, the taxpayer was also advised they would not be entitled to claim any deductions in respect of the arrangement.

It was noted that where there is non-commercial or domestic arrangement, amounts paid for board or lodging do not typically give rise the derivation of assessable income. It follows that the question of income tax deductions for losses and outgoings does not arise (as deductions are only allowed where a taxpayer is producing assessable income – and here the taxpayer was not).

PR 1052163264691

Two taxpayers together owned a residential property as joint tenants and used it as their main residence. They let one bedroom out to a student friend for a market value fee that was subsequently reduced below market value as a gesture of goodwill.

Here, the ATO ruled that the fee was to be assessable as there was a benefit conferred on the taxpayers (a financial gain after covering the occupants costs). As rent charged was below market rates, the taxpayer was only permitted to claim deductions for eligible outgoings up to the value of the rent received.

It was noted that only that portion of an allowable expense which relates to the rental income can be claimed as a deduction. As a general guide, apportionment should be made on a floor-area basis that is, by reference to the floor area of that part of the residence solely occupied by the tenant, together with a reasonable figure for tenant access to the general living areas, including garage and outdoor areas if appliable.

PR – 1052130653288

Two taxpayers together acquired a residential property to house their adult child who was going through a divorce process. It was agreed that the child would make weekly contributions to a savings account to cover property-related expenses such as land tax, insurance, ongoing maintenance, replacement of fixtures, equipment, carpets, blinds, painting and the like. Amounts would not be withdrawn from that account other than to service those causes.

Here, the ATO ruled that the weekly contributions to the account would not be assessable to the taxpayers as they were not obtaining any form of reward under the arrangement. In addition, it was ruled that the taxpayers would not be entitled to any deductions because the purpose of the arrangement was of private or domestic nature.

PR – 1051985868841

The taxpayer owned a residential property which was used as their main residence. The taxpayer let two students a room each and charged a fixed amount per week to cover accommodation, full use of the house and yard, cooking utensils and facilities, household equipment, furniture, fridge, electricity, water, internet access, some groceries and 1 meal each week. All other bills and expenses were the taxpayers responsibility, unless there was excessively high consumption by the students.

Here, the ATO ruled that the fee charged under the arrangement was assessable to the taxpayer as ordinary income under section 6-5 of the ITAA. That is because there was a substantial benefit conferred on the taxpayer (i.e. a financial gain which was more than a negligible amount) when a comparison was run between the students payments and estimated expenses. In addition, the taxpayer was ruled to be entitled to claim a deduction for eligible outgoings under section 8-1 as they had the requisite profit making purpose. However, since the taxpayer was only renting out part of the home, they were only permitted to claim a deduction for expenses related to renting out that part of the home. In addition, they could only claim expenses proportionate to the days in the income year when the room was rented or available for rent.

PR – 1051986965092

The taxpayer owned a residential property used as their main residence with an attached granny flat. The taxpayer let the granny flat out to various friends for varying lengths of time. It was not advertised for rent, there were no formal lease agreements in place and there were no defined time periods that occupants would be staying.

The occupants paid an amount on a weekly basis. That amount was below market value and was considered to be a contribution to the costs of power, water and internet. The taxpayer also provided the occupants with some furniture and other general items.

Here, the ATO ruled that the fee charged under the arrangement should not be assessable to the taxpayer as ordinary income under section 6-5 of the ITAA. Presumedly, because the taxpayer did not obtain a reward or benefit under the arrangement since they charged under market rates and applied amounts received against the costs of facilitating the guests (as opposed to making a net financial benefit after having covered those costs).

PR – 1051918579455

Two taxpayers jointly owned property with a dwelling used as a main residence. The property was subdivided and another dwelling was erected on the land. It was agreed that family members would live in the property and that they would cover payments towards the home loan over the property by direct transfer to the financier. The occupants were solely responsible for repairs and maintenance and all associated expenses.

The purpose of the arrangement and subdividing was to provide the family members with a place to live and eventually have them purchase the property. There was no apparent income producing intention tied into the arrangement.

Here, the ATO ruled that the direct payments by the occupants to pay off the loan should not be assessable to the taxpayers as ordinary income under section 6-5 of the ITAA. Presumedly, because the view was taken that the arrangement was of a domestic nature and/or the taxpayer did not obtain a reward or benefit under the arrangement.

PR – 1051763913156

The taxpayer owned a residential property which they started renting out to a relative. The relative paid weekly rent at slightly below the determined market rate. A number of timber boards on the property deck began to rot and were replaced during the period the relative was renting. Note that the ATO considered the replacement activities to constitute deductible repairs.

Here, the ATO ruled that the rent should be assessable to the taxpayer as ordinary income under section 6-5 of the ITAA. The repair expense incurred was held deductible because the property was being used for income producing purpose. However, it was qualified that because the property was being rented by a relative at below market rates, the arrangement was non-arms length meaning the taxpayer could only claim deductions for eligible outgoings (including for the costs of repairs) up to the amount of rent received.

The main residence exemption is available to disregard the capital gain (or loss) from a majority of CGT events (e.g. CGT event A1 upon sale) that happens to the main residence of a natural person or persons (but not a trust or company) who have an ownership interest and who are resident taxpayers.

However, key conditions for eligibility are that the dwelling must be used as a main residence throughout the period of ownership and not used for the purpose of producing assessable income. Thus, the taxpayer may need to recognise a part capital gain referrable to any period the property was used for the purposes of producing assessable income.

Section 118-190 of the ITAA broadly provides that:

• A taxpayer will only get a partial exemption for a CGT event that happens in relation to a dwelling or the taxpayers ownership interest in it if:
  • [omitted]
  • the dwelling was used for the purpose of producing assessable income during all or part of that period; and
  • the taxpayer had incurred interest on money borrowed to acquire the dwelling, or the taxpayers ownership interest in it, the taxpayer could have deducted some or all of that interest.
• The capital gain or capital loss that would have been made apart from this section is increased by an amount that is reasonable having regard to the extent to which the taxpayer would have been able to deduct the interest.

Based on this test, it is important for a taxpayer with informal rent arrangements to consider whether they have derived assessable income and, if so, whether they would be entitled to any deduction for interest if the property had been hypothetically acquired on finance. For any period of time those two tests are satisfied, the taxpayer is exposed to recognition of a capital gain.

Keep in mind that for the purposes of paragraph (c), the main residence exemption may not available in respect of a period where even a small amount of interest would be deductible. For example, assume a person with a main residence had a total ownership period of 10 years. After the first year of the ownership period, the taxpayer rents out a single room which returns assessable income and which enables the taxpayer to claim 20% of the interest on their home loan (20% being a reflection of the floor area attributable to the income producing purpose). In this circumstance, the taxpayer would only be entitled to a utilise the main residence exemption for the first year. The fact the taxpayer was only entitled to claim 20% of the interest on their home as a deduction does not prevent the total loss of the main residence exemption between year 2 and year 10 (when the taxpayer let out a bedroom).

It is also worth flagging that there may be circumstances where a taxpayer can utilise the absence rule (in section 118-145 of the ITAA) and the compulsory acquisition rule (in section 118-147) to override exposure to CGT that would otherwise arise from using the property to produce assessable income.

Section 118-190(3) and (4) broadly provides:

The taxpayer can ignore any use of the dwelling for the purpose of producing assessable income during any period that they continue to treat it as their main residence under section 118-145 or 118-147 to the extent that any part of it/the old dwelling was not used for that purpose just before it/the old dwelling last ceased to be the taxpayers main residence.

By way of reminder, the absence rule in section 118-145 permits a taxpayer who used a dwelling as their main residence to continue to treat it as their main residence during periods where it is no longer used as a main residence (e.g. a period where the taxpayer is absent but continues to own the home) thereby reducing exposure to CGT during those periods.

Where the property is used for the purpose of producing assessable income, the property can only be notionally treated as a main residence for maximum period of 6 years. However, that 6-year period can be reset if the dwelling again becomes the main residence of the taxpayer.

By way caution, note that to be eligible to take advantage of the absence rule, the taxpayer needs to have actually stopped residing in the property. Therefore, the absence rule may not be available where a taxpayer is, for example, renting out a particular room but continuing to live in the property and use it as a main residence.

Granny Flat Arrangements

The grant of a right to occupy a dwelling can be a trigger for CGT – potentially not only at the point the right is granted, but also when the right is varied or terminated.

However, it is worth flagging that there was a recent legislative concession brought in to mitigate CGT outcomes in respect of arrangements which met the criteria to qualify as eligible granny flat arrangements. The concessions are designed for occupants who are at least of pension-age or for persons who are disabled. If eligible, a CGT event will be considered not to happen (and thereby no CGT trigger) where a granny flat interest is granted, varied or terminated.

There are a number of key eligibility criteria which are expressed in Division 137 of the ITAA and which are broadly summarised below:

For a granny flat arrangements entered into/granted or varied

The relevant individual (granted the right to reside) must hold a granny flat interest under a qualifying arrangement. That means the individual must be granted the right to occupy the dwelling for life as a right conferred under an arrangement.

The relevant individual must be eligible for a granny flat interest. That can be achieved by: (a) the individual having reached pension age at or before the relevant time; or (b) the individual:

needing, because of a disability, assistance to carry out most day-to-day activities; and

being likely to continue to need that assistance, because of that disability, for at least 12 months after that time.

The arrangement (or arrangement as varied) must be recorded in writing and indicate an intention for the parties to the arrangement to be legally bound by it.

Another individual must hold an ownership interest in the dwelling at the relevant time (start time of the grant or at the variation time) or another individual must agree under the arrangement to acquire an ownership interest in a dwelling that is to be the dwelling in which the first-mentioned individual is to hold the granny flat interest.

At the relevant time (start time of the grant or at the variation time), both individuals must be parties to the arrangement.

The arrangement (or arrangement as varied) must not be of a commercial nature.

For a granny flat arrangement that is terminated

Section 137-15 (about the grant of a right) or section 137-20 (about the variation of a right) applied so that that a CGT event did not happen when the arrangement was entered into or when the arrangement was varied.