Taxation Law: Advice on Inherited Property and Deductibility of Expenses

PRINCIPLES OF TAXATION LAW
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Question 1
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 19971. 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
residence2 (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
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>

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 Ltd3 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 19974. 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 base5.
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 death6.
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 year7. Hence capital gains subject to CGT = 0.5*950,000 = $ 475,000
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