Don't just assume you'll be able to claim a tax deduction on the interest you're paying on the loan for your 'investment' property.

There are some fundamental principles in our tax system about the tax deductibility of interest payments, one of which is that your property must be used to derive assessable income. No income, no deduction. And at current interest rates that can add up to 48,000 of lost deductions for every $100,000 of borrowings, year after year.

If you've borrowed money to buy a house or flat that you'll rent out full-time, there's usually no problem with deducting the interest on the mortgage. But some property investments can fall outside the parameters:

• A holiday home has to be "on the rental market" and available for short-term or long-term leasing to attract tax deductions. And you have to charge a market rent – anything less and you must apportion income and deductions accordingly. In some cases, if the Australia Taxation Office decides you're not serious about rentals, you could miss out even though you've earned a small amount of income. So, if you're buying a holiday home for use by yourself, your family or friends, be prepared to carry the interest burden.
  
  
• If a property is derelict, you can't rent it out – and there's no income.

• If you plan to hold onto vacant land for an opportunity in the distant future, there's no income-producing activity going. You'll have a genuine investment property but, with no income, no deduction for loan interest.
  
  
• You might buy a property as an investment but make it your temporary home for now. Again, it's one thing to have an investment purpose, but you still need the income to qualify for the tax deduction.
  
  
• If part of a property is income-producing and part not – for example, where there's a shop downstairs and a residence upstairs – interest must be apportioned between the income-producing and non-income producing activities.

There are some situations where you may qualify for a deduction even though there's no income being derived – for example, a loan taken out to pay for construction of an income-producing asset. In this instance, you might get the interest deduction for the period of construction.

If you've bought a property as an investment you should keep all receipts and records to do with interest on your loans, land tax insurance, rates and repairs. These will all be bundled into the "cost base" of the property when capital gains tax is calculated upon its sale or disposal. At this point, it doesn't matter that a property never produced a bean of income – you'll at least get a delayed tax benefit on your way out of the property.

However, there's one qualification: you have to make a capital gain on the property – these acquisition and holding expenses can only be offset against a capital gain.

Having said that, in principle there's no deduction if there's no income, case law tells us it is possible to own a property and get a deduction for interest payments even though a property is not yet producing income – it's just a question of timing.

The ATO applies some tests and, accordingly to taxation ruling 2004/4, you pass if:

• The interest is not incurred "too soon", is not preliminary to the income-earning activities and is not a prelude to those activities.
  
  
• The interest is not private or domestic.
  
  
• The period of interest outgoings before the derivation of relevant assessable income is not so long – taking into account the kind of income-earning activities involved – that the necessary connection between outgoings and assessable income is lost.
  
  
• The interest is incurred with one end in view – to gain or produce assessable income.
  
  
• Continuing efforts are carried out in pursuit of gaining income.

So if there's a long gap between buying the property and income flowing you could fall foul of the "too soon" hurdle. Generally, it seems to ATO is not too worried about the normal situation of buying a residential property and getting it ready for rental or a site being prepared for construction. But tread carefully with vacant land and in circumstances where building plans are a long way off.

The point of the "too soon" guideline is to look at a delay as an indication that your current loan expenditure may have nothing to do with eventually earning income from the property. A delay suggests there's some other purpose in the mind of the owner.

The guideline of "continuing efforts" is not too restrictive. Delays and setbacks are understandable. But you wouldn't want your behavior to give rise to the interpretation that subdivision, for example, wasn't ever the genuine intention, that you're really just holding on to the vacant land for a non-income-producing purpose.

What might that alternative purpose be? Perhaps the owner doesn't give a hoot about income from the site and simply wants to hold on to it to make a capital gain It might become a home and hobby farm for personal use after all. Or you might be holding the land for a child.

The ATO says there should be a connection between your current situation and the eventual income-producing function of the property. It might look at the usual time frame for development of a property such as yours. Have your income-producing plans for the site hit a hurdle or have they died?

Try not to leave room for this kind of interpretation. If your property is without income.

Have a demonstrable, written plan of development with the objective of gaining assessable income in the not-too-distant future. Be genuine, and let the record confirm this. Keep a diary.

When buying vacant land or a derelict property, consider how you can derive income if your plans are on hold or while you look to the long-term development of the site through zoning changes, subdivision or construction once you can afford it.

Fix up the structure so it can be secured and rented out. The potential use might be unexpected – it might become someone's home while he builds nearby. If the environment is rural, the site might provide pasture for horses or stock.

You could check with the council to see if the proposed activity meets requirements, and you should consider the impact on neighbours.

Be aware that your tax deduction might be limited – for example, to the value of the income derived. Talk to your accountant first.

Peter Cerexh is a property authority and has worked as a lawyer specializing in the field.

Smart Investor

May 2007