Q&A: Interest and Other Expenses Where Property Is Negatively Geared

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Q. I have recently purchased a house for approximately $800,000. I intend to redevelop it as a family home. Ninety per cent of the purchase price was financed by a loan. In due course, I will engage an architect to draw up plans for a new house and then lodge a development application with the local council. When the new house is finished, my family will move in. The whole process could take a couple of years. In the meantime, I will rent out the house for approximately $350 to $400 a week.

The outgoings in relation to the property (interest payments, local government rates, water rates, maintenance costs, etc) will exceed the rental income. Can I claim a deduction for the outgoings while it is rented out?

A. The Commissioner’s views on whether interest and other outgoings can be deducted where a property is negatively geared are set out in Taxation Ruling TR 95/33Relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings.

The points made in the Ruling are listed below.

Taxation Ruling TR 95/33

  • If the outgoings produce no assessable income, or the amount of assessable income is less than the amount of the outgoings, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoings are wholly deductible, including the taxpayer’s subjective purpose, motive or intention in making the outgoing.
  • If it can be concluded, after weighing all the circumstances, including the direct and indirect objectives and advantages, in a commonsense and practical manner, that the expenditure is genuinely, and not “colourably”, used in an assessable income-producing activity, a deduction is allowable for the loss or outgoings.
  • If, however, it is concluded that the disproportion between the outgoing and the assessable income is essentially to be explained by reference to the independent pursuit of some other objective (eg to derive exempt income or to obtain a tax deduction), the outgoing must be apportioned between the pursuit of assessable income and the other objective.
  • When considering the subjective purpose, motive or intention in incurring a loss or outgoing, regard must be had to the purpose or motive that the taxpayer had in mind when the loss or outgoing was incurred.
  • A reference to the relevant assessable income or allowable deductions does not necessarily refer to income produced, or the expenditure incurred, in a particular income year. For example, if income is expected to be produced over a number of years from a single transaction, it will be necessary to total the relevant assessable income reasonably likely to be produced during that period and compare it with the total expenditure reasonably likely to be incurred.
  • When it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both “fair and reasonable” in the circumstances.

Fletcher v FCT

Note also that TR 95/33 was issued following the decision of the High Court in Fletcher v FCT (1991) 22 ATR 613 in which the Court held that it was necessary to apportion outgoings in relation to an annuity scheme that was not intended to run its full course and generate positive assessable income to the investor – with the result that there was a “significant disproportion between the deductible outgoings and the assessable income”. However, if the “disproportion” was to be explained by the pursuit of some other objective (a “colourable purpose”) it would be necessary to apportion the outgoing between the pursuit of assessable income and the other objective.

Analysis

The first question to consider is whether the interest is deductible. Whether interest is deductible is determined by looking at the purpose of the loan and how the loan is used. Ordinarily, the purpose of the loan can be ascertained from the use to which the loan is put.

In this case, the loan was taken out to acquire a property that is to become the family home. This suggests that the interest payments would not be deductible as the loan money is to be used for private and domestic purposes. However, as the property will produce income in the meantime, it is arguable that some, if not all, of the interest payments may be deductible during the period the house is rented out and income is being earned.

An apportionment of the interest and other outgoings may be appropriate in this case for the reasons listed below.

  1. There is likely to be a “significant disproportion between the deductible outgoings and the assessable income over the relevant period”.
  2. The rental income producing activities are clearly intended to end at a specified date (within a couple of years) when the house is knocked down so it can be rebuilt (similar to the annuity arrangement in the Fletcher case).
  3. The subjective purpose exercise required in such circumstances would suggest that the incurrence of the outgoings is “coloured” or motivated by another purpose or objective – perhaps something akin to “holding costs” for the construction of a non-income producing asset, namely your new home.
  4. The arrangement does not appear to be the “commonly encountered” kind of negative gearing arrangement in terms of a “commonsense or practical weighing of all the factors surrounding the acquisition of the property” – especially as it is stated that the property was acquired for the purpose of building the taxpayers’ new home.
  5. If there is, in fact, a relevant “disproportion” between assessable income and outgoings and this is explicable or coloured by a non-income producing (subjective) purpose on the part of the taxpayer, it will presumably be necessary to apportion the outgoings on a “fair and reasonable” basis in the circumstances. It may be appropriate to limit the deduction for the relevant outgoings to the amount of income derived. This may also be appropriate in a case such as this where the outgoings seem more akin to “holding costs”.

Contact us

The above is a discussion only and further advice should be obtained. Please contact our office on 02 9954 3843. to discuss your circumstances and to obtain professional advice.

This article is adapted from Thomson Reuters Tax Q&A service.