Deductibility of Interest During Construction

12 May 2011 - David Maynard(Guest Writer of Property Investment Wise)

Deductibility of Interest during the Construction Period of an Investment Property Project.

There has been a quantum shift in the view of deductibility of interest expense during the construction period of an Investment Property Construction Project. The shift from the ATO’s traditional view to the current position is good news for Property Investors.

Typical scenario: Investor purchases land, constructs a dwelling and, on completion of construction, rents the property for the market rate.

The traditional view in this scenario was interest (and borrowing costs) was not deductible as there was no connection between income until the property became available for rent. In other words, the interest expense was incurred too early to be deductible. Instead, the interest expense was treated as a capital cost which formed part of the cost base of the project for Capital Gains Tax (CGT) purposes and tax deductibility was either lost or deferred.

A recent court case and subsequent Australian Taxation office (ATO) rulings and interpretive decisions has changed that view. The current view in this scenario is that interest is deductible, providing the following circumstances apply:

• The interest expense was not incurred ‘too soon’ as to be a prelude to income earning activities;
• The interest expense is not ‘private or domestic’ in nature;
• The interest expense is not incurred ‘too remotely’ from the time of income earning activities
• The interest expense is incurred with ‘one view’…income production;
• Continuing efforts are made to realise that view.

Based on the above, interest incurred on borrowings used for the construction of a rental property should be deductible from the outset of the loan.

In practice, it would be prudent to obtain and retain documentation and other evidence consistent with the intention to construct the dwelling and earn rental income. Documents evidencing loan applications (ie. purpose of loan), details of market rents in the area, enquiries and or negotiations with rental agents; budgets and projections prepared by or on behalf of the taxpayer, professional consultations (eg. accountant) etc.

The current position on deducibility of interest during the construction period of an Investment Property Project is a quantum shift from the traditional ATO view. It is also a position that to date has escaped many accounting/taxation professionals so Property Investors need to be prudent in seeking advice that is current.

Amendment Requests: A final note on this topic – It is not uncommon for our practice to request amendments to correct omissions in prior year returns. In some cases amendments can result in additional refunds of thousands of dollars. If you believe that deductions of interest in the above circumstances have been omitted from prior year returns, you can contact our office to discuss the matter further. Once lodged, amended returns and refunds are processed within two weeks.

Note: Amendments are now only available up to two years after date the return was assessed by the ATO.