The key objective is to tender advice Tony and Hub in relation to the various scenarios with regards to the inherited property which was used as a main residence before Joe was dead.
Scenario 1: “Keep renting out the property and leave everything as it is”
In this case, the income derived in the form of rent (i.e. $ 12,000 in the last eight months) would be treated as ordinary income under s. 6(5) ITAA 1997[1]. Further, this would contribute to assessable income for Tony and Hub and would be divided between the two in the ratio of their inheritance of the property.
With regards to CGT consequences, the inheritance does not result in any particular capital event. Thus, till the time the brother decide to sell the property, there would not be any CGT implications. The precise implications would be dependent on the timing and nature of the sale.
Scenario 2: “Sell the house now and invest proceeds into shares or other investment”
With regards to inherited dwellings where the asset was acquired in the pre-CGT era (i.e. before September 20, 1985) and the acquirer died after September 20, 1985, then such an inherited dwelling would be exempt from CGT for a period of two years from the date of inheritance irrespective of the fact whether the residence is used for income purposes or main residence[2] (s. 118-195 ITAA 1997). In the given case, it is apparent that the house building was completed by Joe in 1974 i.e. pre CGT era. However, death of Joe has taken place after September 20, 1985. Thus, CGT exemption can be availed if the house is sold immediately even though the house has been used for income production. The important aspect is that only 18 months have passé since Joe’s death.
The proceeds from the sale would be capital and non-taxable. Further, no CGT implications would arise. With regards to investing the proceeds in another asset, the taxable income may be derived from the new asset.
Scenario 3: Relocation of existing house and building of new house
Clearly, since the existing house is being stripped off and then renovated like new, this it would not be recognised as repairs but instead would be categorised as improvements. This is in line with the discussion in FCT v Western Suburbs Cinemas Ltd[3] case. As a result, the concerned expenditure would be capital in nature and not revenue. Thus, no deduction under s.8-1 is available for the $ 200,000 which is not for repairs and hence non-deductible under s. 25-10 ITAA 1997[4]. Further, the new house cost of $ 250,000 along with the improvement would be added to the capital base of the asset (i.e. property) in line with s. 110-25 ITAA 1997 where any costs incurred to bring significant improvement in the value of the asset are considered as part of the capital base[5].
Hence, the construction of the new house and improvement in the old house has no implications for income but merely increases the cost base of the property by $ 450,000 which would be reflected when the property would be sold.
Scenario 4.1: “Divide the title and sell both houses”
In this case, there are two assets which need to be treated separately for the purpose of deriving the CGT. However, since both the assets are being sold hence these can be clubbed for sake of CGT computation. The cost of acquisition of the inherited property would be $ 1,000,000 since this is the market value on the day of Joe’s death[6].
Cost of acquisition of property = $ 1,000,000
Cost of improvement of property = $ 450,000
Cost base of the property consisting of two houses = $1,000,000 + $ 450,000 = $ 1,450,000
Sales proceeds = $ 1,200,000*2 = $ 2,400,000
Capital gains realised (if the houses are sold after 2 years from death which is likely considering 18 months have already passed) = $2,4000,000 – $ 1,450,000 = $ 950,000
Under division 115, 50% discount would be available considering that holding period is more than a year[7]. Hence capital gains subject to CGT = 0.5*950,000 = $ 475,000
Scenario 4.2: “Retain the title and sell both houses after 5 years”
The rent income realised by the brothers before sale of the two houses would be assessable income in accordance with s. 6(5) ITAA 1997. The cost base in this case for the whole property including two houses would amount to $ 450,000. However, the selling price for the two houses would be $ 4,800,000.
Hence, capital gains realised = $ 4,800,000 – $ 1,450,000 = $3,350,000
After availing Division 115 discount , taxable capital gains = 0.5*3350000 = $1,675,000
The objective is to tender tax advice to Monica in relation to deductibility of the various outgoings that have been incurred in wake of the given information.
It is apparent that the money spent by Monica to the tune of $ 500,000 is for the purchase of a asset (property) which would be used for income generation. Thus, one possible avenue for deduction could be s. 8-1 ITAA 1997[8]. However, one of the negative limbs as specified in subsection 8-1(2) is that capital outgoings are not tax deductible. Clearly, the $500,000 is a capital expenditure since it is used for an asset procurement and not trading stock and hence no deduction can be availed under s. 8-1.For deduction on capital expenditure s. 40-880[9] might be relevant but a key requirement is that the expenditure should be business related which is not satisfied in this case. Hence, no tax deduction can be avoided on the outgoings of $ 500,000 for the property.
Establishment Fee – The establishment fee for the loan would be considered as borrowing expenses and since it is used for producing of assessable income in the form of rent hence in accordance with s. 25-25 ITAA 1997[10], the complete amount of $ 2,000 would be deductible over the tenure of the loan.
Interest & Principal –In accordance with decision in the Steele vDCT[11], it is apparent that interest expense related to any asset which would be used to produce assessable income would be tax deductible. In the given case, Monica has assumed debt for purchase of rental property and since rent is assessable income under s. 6(5) ITAA 1997[12], hence interest expenditure would be deductible. However, the principal repayment would be capital outgoing and hence not deductible under s. 8-1.
Expenditure on repair and maintenance may be completely deductible under s. 25-10 ITAA 1997[13] in the year of incurring of the expenses when the underlying property is being used for assessable income production. However, it is noticeable that when the repairs are done before renting, then these are termed as initial repairs and considered to be capital expenditure which is non-deductible under s. 25-10. Instead, these are added into the cost base of the asset i.e. rental property in this case and not available for tax deduction.
In accordance with s. 25-35(1) ITAA 1997[14], a deduction for a debt categorised as doubtful debt can be made only if it was included as assessable income either in the previous year or in the current year. Thus, deduction can be made if Monica adds $ 500 as ordinary income in the current year tax computations. However, if Monica does not consider $ 500 as income, then no deduction for doubtful debt can be made
With regards to deductibility of travel expenses, the verdict of the FCT v Payne[15]is critical which highlights that the travel expenses incurred by the taxpayer between two unrelated work places would not be deductible under s.8(1) as the incurred travel expenses enables the taxpayer to be in the “position to produce assessable income” but does not lead to produce of assessable income. Going by this, the $500 expenses on transport between office and university incurred by Monica do not seem to be tax deductible. However, s. 25-100(1) ITAA 1997[16] states that any expenses related to travelling between two income producing activities are deductible for tax purposes. Assuming Monica is paid for teaching, the travel expense would be tax deductible. However, if Monica does not charge anything from the university, then the travel expenses would not be deductible for tax purposes.
It is apparent that membership of Financial Planners Association has direct relationship with the profession of financial advisor and hence the membership contributes to the assessable income production. As a result, it would be deductible under s. 8-1 as business expenses. With regards to the membership of the golf club, it is clear that Monica is a keen golfer but the same is also used for entertaining clients. Clearly, the entertaining of clients is sufficiently closely linked to the profession of financial advisor where relationship building is of paramount importance. It is apparent that the golf membership related expense would pass the essential character test and would be thus deductible under s.8-1 as outlined in the Hayley v FCT[17].
References
[1] Reuters, Thomson, Australian Tax Legislation (THOMSON REUTERS, 2017)
[2] ATO, CGT Exemptions for Inherited Dwellings < https://www.ato.gov.au/General/Capital-gains-tax/Deceased-estates-and-inheritances/Inherited-dwellings/CGT-exemptions-for-inherited-dwellings/#Deceasedacquiredthedwellingbefore20Septe>
[3] FCT v Western Suburbs Cinemas Ltd (1952) HCA 28
[4] Krever Richard, Australian Taxation Law Cases 2017 (THOMSON LAWBOOK Company, 2017)
[5] Barkoczy, Stephen, et al, Australian Taxation Law 2017 (Oxford University Press Australia., 27thed, 2017)
[6] Ibid. 4
[7] Ibid. 5
[8]ATO, Taxation Ruling TR 97/7, Income tax: section 8-1 – Meaning of incurred – timing of deductions. https://law.ato.gov.au/atolaw/view.htm?Docid=TXR/TR977/NAT/ATO/00001
[9]ATO, Business related costs- section 40-880 deductions. https://www.ato.gov.au/Forms/Guide-to-depreciating-assets-2007-08/?page=81
[10]ATO, Income Tax, Rental Property Expenses- deductibility of loan establishment fees. https://www.ato.gov.au/law/view/document?docid=AID/AID200542/00001
[11]Steele v DCT (1999) HCA 7
[12]ATO, Income Tax. Assessability of an Australian sourced interest income received by a Sri Lankan resident. https://law.ato.gov.au/atolaw/view.htm?docid=AID/AID200723/00001
[13]ATO, Taxation Ruling, TR 97/23. Income tax : deductions for repairs. https://www.ato.gov.au/law/view/document?docid=TXR/TR9723/nat/ato/00001
[14] ATO, ATO Interpretative Decision, Deductions and expenses: Bad Debt (Loan by beneficiary to truat. https://www.ato.gov.au/law/view/document?docid=AID/AID2001301/00001
[15]FCT v Payne (2001) 46 ATR 228
[16]Barkoczy Stephen, Core Tax Legislation and Study Guide 2017 (Oxford University Press Australia, 2017)
[17]Hayley v FCT (1958) 100 CLR 478
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