Apportionment for CGT and loan interest deduction for main residence partially used for rental

Question

I am purchasing a property on one title and contract has exchanged. I’m about to set up my loan, and have been thinking about how to account for the rental part of the property.

I will live in a 2 bedroom house with an attached 2 bedroom granny flat which I will be renting out. Both parts of the property are well fenced and clearly delineated from each other. The land is large (5,500m2) and most of it is fenced to belong to the house. I purchased the property at $495,000. I estimate the land value to be approx $350,000. I estimate that the floor area of the rental part is 45% of all of the floor area, whereas the land occupied by the rental is only 5% of the total land.

My questions relate to method of apportionment for the purpose of determining CGT (if and when a CGT event occurs) and for the loan interest deduction:

1. Using the floor area apportionment for CGT would not reflect the market value of the rental portion of my property. Can I use a valuer and establish a cost base for the rental property portion?

2. For loan interest deduction, I understand that the apportionment should be consistent with the CGT apportionment, so should also be based on the initial valuation. Am I correct? I would like to set up two loan contracts to separately account for interest incurred with the money borrowed for the investment portion of the property because I would like to pay off my own residence at a faster rate. Would this be considered acceptable by the ATO?

3. For deduction of other expenses, will I still be able to use floor area for apportionment of shared expenses eg water, electricity, council rates, building insurance?

Regards,
Karmen

Answer


Generally the percentage used to apportion rates and interest will be the same as the percentage used to apportion the part of the property that is covered by your main residence exemption. So there is probably not much advantage in skewing it in either directions but the floor area of the buildings is more relevant than the yard area. This is the case even when the land is of such high value because you are more looking at what you are receiving the rent for. The size of the back yard does not normally change the amount of rent received by much. Now these methods are not set in cement they are just a summary of ATO examples. If you feel that you will be advantaged by apportioning less to the granny flat because you are not interested so much in deductions now but protecting future capital gain, then it is worth applying to the ATO for a ruling on the method of apportionment rather than miss out of deductions now only to have them tell you, when you make a capital gain, that they disagree with your method of apportionment but it is too late to go back and amend tax returns to claim the extra interest.

Here is an extract from IT 2167 that discusses the issue of apportionment:
10. The situations represented under this heading call for apportionment of expenditures incurred in respect of the residence to determine what amounts may be allowed as income tax deductions. Inevitably it will be a question for decision in each case. As a general approach apportionment should be made on a floor area basis, i.e. by reference to the floor area of the residence to which the tenant/lodger has sole occupancy together with a reasonable figure for access to the general living areas including garage and outdoor areas. If, for example, the tenant/lodger had sole occupation of one room in the residence and shared the general living areas equally with the owner/occupier, it would be appropriate to add one half of the floor area of the general living areas to the floor area of the room of sole occupancy in order to make the necessary apportionment. In some cases access to the general living area may be restricted to the kitchen, bathroom, a laundry – it would be necessary to restrict the reasonable figure for access to general living areas to those rooms.



Again from IT 2167

Expenditure on repainting a room let to a tenant for the whole of a year would qualify for deduction in full under section 53 but the cost of repainting the entire house would need to be apportioned. It will be a question of applying the relevant provisions of the income tax law to each claim for deduction.



Note it would be this comment that each expense needs to be looked at and apportioned individually that you would use to argue that the interest on the loan should be apportioned differently to say the electricity because of the different values of the properties. Taking this a little further why not set up two separate loans


Carberry’s case maybe useful to you if you have a worthwhile deposit on the property and you want that deposit to reduce only the loan for your share of the property. Normally the ATO would just say apportionment as stated above. But in Canberry’s case the taxpayers were allowed to apply their deposit only to their part of the property:
In Carberry’s case 88 ATC 5005, a married couple were allowed a deduction for the full amount of interest on a loan used to purchase a combined dwelling/child-minding business, where it was shown that the whole of the loan related to the purchase of the business and the dwelling was purchased with the proceeds from the sale of their previous home.
In IT 2661 the ATO comment on this case, saying:
11. The approach adopted by the Federal Court is accepted in the special circumstances of the case. Essentially, the issue involved was whether it is possible, when a single asset is purchased using borrowings and there is a dual business and non-business purpose in the acquisition, to apply the whole of the borrowings to the business purpose and to allow a deduction for the interest paid on the whole of the borrowings.
12. In certain cases, such as Carberry, a single asset (such as land with a single title) may be capable of being properly regarded as having been notionally divided between a part acquired with a business purpose and a part acquired with a non-business purpose. In such a case, borrowings may be properly regarded as relating to the notional part of the asset acquired for a business purpose and a deduction will be allowed for the full amount of interest paid in respect of the borrowings.
13. However, for this method of apportionment to apply, it must be shown that the borrowings in fact relate solely to the notional part of the asset acquired for business purposes. In Carberry, for instance, the taxpayers were able to show that the part of the asset purchased for private purposes was paid for with the monies which the taxpayers had received from the sale of their previous residence. Accordingly, it was open to the Tribunal to find that part of the asset purchased for business purposes was in fact purchased with the borrowed funds.




So again based on the statement that you need to look at each claim you could use a different apportionment percentage if it is realistic to apportion electricity etc. You then of course have the problem of which one should be used on the CGT. All other material that I am aware of assumes you have one percentage and that is the percentage you apply to the capital gain.

Sorry, more questions than answers, I am assuming that a valuer would give the granny flat less than 45% of the purchase price:
1) Do you have a decent deposit and can you set the loans up separately?
2) Are you prepared to forgo interest deductions now so that a lesser percentage of the capital gain is not covered by your main residence exemption? Might need a crystal ball for this one.

Under the circumstances ie long period of time covered, possible large capital gain and unable to amend back more than 4 years. I suggest you obtain an ATO ruling before you apportion on any method other than floor area. The above gives you the basis of your argument in the ruling or can make up research notes that you relied on in choosing a different method of apportionment to show that you were not reckless, if you ever get audited.

It is certainly worth persuing separate loans.

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