Claiming Interest as expense with intention to further develop a rental property

Question

Hello Julia

Apologies for the long question, but I would like to start of with a detailed context to my question, in order for you to gain a proper understanding of our situation.

In July 2007 my husband and I purchased an investment property in inner city Brisbane. The property was on two lots, with a DA in place to slice the existing house, leaving a renovator and a vacant block of land, with preapproved Council plans for a new home (for the vacant block) and a renovated home. At the time of purchase, our intention was to:

a) carry out the DA by renovating the existing home, and a building a new home on the vacant lot and
b) keep both houses as rental investments

Initially, following purchase, we rented out the property as is, while we got organised for the proposed DA works e.g met with builders, architects etc.

In early 2008, while the property was tenanted for a small sum, we learned from the tenant, that the house was literally falling apart and unsafe to live in. We were unable to relet it.

In mid 2008, we got a structural report from an engineer, who confirmed that the house was not suitable to live in, as it was unsafe. At this time, we still had the intention of carrying out the DA and using both houses for rental purposes. In August 2008, we applied to the Brisbane City Council for a new DA to remove the existing house altogether, as according to the engineer and builder, it was dilapidated. Our intention was to build two new homes, rather than renovate a home that was dilapidated. In Dec 2008, the Brisbane City Council rejected our application and we had to revert back to the original DA i.e building one new home and one renovated house.

In March 2009, we found we needed to sell one of the two lots, as the peak in interest rates and the Global Financial Crisis was heavily impacting on our affordability of this site. We found that the rising interest rates were quite difficult to manage, as we also had other investment properties in our portfolio. We listed both lots for sale, and thought we would sell either the vacant land or the renovator, to help reduce our bank repayments. Our intention was still to keep whichever lot didn’t sell, and build for a rental.

As circumstances went, we actually got a low offer on each lot, and decided to sell both, to reduce our debt levels. We found we could not make payments on our existing obligations.

Our question to you is: Can we claim the interest on this property as a rental expense, from early 2008, as our intention was to build two rental properties all along, or must the interest be added to the cost base in the 08/09 year (when it was sold). We did not receive any rent during this period, as the house was not fit to live in, but the intention to build new rentals was there, as we were pursuing a DA to demolish and build two new rentals…until circumstances forced us to sell. Our accountant is claiming that as we did not receive any rent, that we would not be entitled to claim the interest as we sold it in the financial year in question. He went on to further state that the ATO would definitely audit us in this circumstance.

Since this time, we have actually built two executive rentals which are being rented, with a third almost complete and ready to let. We believe this would demonstrate our strategy and intention to build executive homes for rent. The circumstance relating to the above was purely as a result of our affordability, where we decided we just needed to reduce our debt levels before we were unable to make bank repayments.

Thank you very much for your advice.

Kind regards
Asha Jeet.

Answer

Asha
I totally disagree with your accountant. Please refer him to the ATO rental booklet, depending on the year somewhere between page 9 and page 12 you will find where the ATO even says you can claim interest during construction of the property right up to the time you change your mind and decide to hold it for some other purpose. This is based on Steele’s case where as long as there was a continuing process showing rental was your eventual intention then the interest was deductible. Another example of this is Ormiston’s case AAT 2005 where he mucked about for 4 years renovating a property. He never finished it and sold it not ever having earned a cent in rent yet was entitled to claim over $70,000 in holding costs. Your argument is not based on whether rent was actually received but instead what your intentions were.
The ATO tests the tax returns lodged by tax agents to see if they go outside industry norms. Personally when an officer from the ATO comes out to investigate me saying I have breach these norms, I ask can I have it in writing so I can put it in the window. Your accountant may be more intimidated by them. The question is are you?
I certainly recommend that you pursue the intention to build rental accommodation argument otherwise you would be required to have charged GST on the sale. The vacant block would simply be subject to GST because it is vacant land. If the house is unlivable you would also be considered to be selling vacant land. Now if they are held as part of the turnover of your business ie the primary purpose of your business is to profit from their resale then you should register and charge GST. So this question is not just about when to claim the interest.

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