LAW301 Rental Expenses and Tax Implications Questions Assessment Answer

This test consists of 3 questions. All answers must be referenced with the appropriate section of the Statuary Law and/or Case Law.

Question 1(5marks):

Kim Lyons purchased a house in Brisbane, Queensland on 1 December 2018 for $600000 as a long-term investment. She then decided to rent the house out to a tenant from the date of purchase for $700 per week. Kim provides you with the following information in respect of the house purchase:

A loan of $400,000 was taken out on 1 December 2018 for 20 years to purchase the house. Interest paid on the loan for the tax year ended 30 June 2019 was $28,000. The legal fees, loan charges and stamp duty paid in relation to the loan were $10,000.
The roof on the house was damaged and was replaced at the time of purchase for $22,000.
One of the bedrooms was repainted on 15 April 2019 at a cost of $1,200.
The timber floor in the outside laundry was replaced with a concrete floor on 1 April 2019 at a cost of $4,000. The floor was replaced due to water damage caused by a leaking pipe.
A gas heater was purchased on 18 June 2019 for $5200. The heater had an effective life of 10 years.

Kim seeks your advice as to what deductions (if any) she might be able to claim regarding the above expenditure for the 2018/19 tax year.

Question 2(5marks):

Jenny Jones is a freelance architect and commenced business in August 2019. She operates her business from her home in Jolimont and uses two rooms in the sixroom house for work.

Most of her work has been in relation to small clients. In March 2020 Jenny was offered a large consulting job with the Victoria Government worth $150,000. Consequently, in March 2020 Jenny employed Jon Jonson, a recent university graduate, at a cost of $45,000 to help her with the work. Jon was employed part time on a three-day per week basis. Because of the demands of the government job, it is likely that Jenny will need to take on more support staff or reduce her other private client work.

For the year ending 30 June 2020 Jenny earned the following income: o $110,000 - cash o $30,000—amount owing by customers (including the Queensland Government). Her home and other expenses were: · Rates: $3,000

Interest on mortgage: $24,500
Insurance: $1,250
Utilities: $4,500
Salaries: $15,000
Local advertising: $2,400
Desk, computers and printers: $12,000
Car—Toyota Corolla: $24,000 (acquired 1 August 2019). It has travelled 11,000 kilometres of which 60% was work related. Running costs excluding depreciation were $5,800.
Determine Jenny’s taxable income for the year ending 30 June 2020.
On 15 May 2020 Jenny’s accountant suggested she form a company for her work in order to protect her liability and for advantageous tax reasons.

Required

Advise Jenny whether this would raise any tax issues with the ATO.

Topics covered in this question

Assessable income, Deductions and Alienation of income

Question 3(10 marks):

Bill and Fred Leman had been very successful financially. On the death of their father in June 1990, the brothers had inherited a hotel called ‘The Golden Arms’ and 50 hectares of land in a prime residential area of the Mornington Peninsula in Victoria.

Their father had built the hotel in 1976 at a total cost of $600,000 (land $375,000 and building $225,000) and paid a further $120,000 for the hotel’s licence to sell alcohol. In June 1989, their father increased the size of the hotel by 50% by building a new wing on the eastern end of the hotel at a total cost of $150,000.

Two weeks after their father’s death, Bill and Fred were offered $1,500,000 for the hotel building (which included the new extension which was valued at $330,000) and $300,000 for the licence to sell alcohol. The brothers declined to sell, although the local estate agent deemed the offer to be a good price as the land alone was valued at $600,000 at the time.

The 50 hectares of land on the Mornington Peninsula was acquired by their father in November 1989 for $1,500,000. He had originally intended to retire to the property and establish a vineyard.

After their father’s death, Bill and Fred had structured their affairs so that The Golden Arms Hotel was operated as a partnership, with each brother having a 50% interest in the business.

In June 1991, the brothers formed a company (Leman Pty Ltd) which issued both Fred and Bill with 1,500,000 non-redeemable ordinary shares paid up to $1.50 each in consideration for the title to the Mornington Peninsula land, which after their father’s death they had jointly owned.

At the time of the transfer, the land had a market value of $3,000,000. Fred and Bill were the sole shareholders and directors of Leman Pty Ltd. After acquiring the land, Leman Pty Ltd proceeded to develop it. The company constructed roads and subdivided the land into 100 half-hectare lots. The cost of the subdivision, incurred in the March quarter of 1992, was $300,000.

In the September quarter of 1992, 50 lots were sold to private owners for an average price of $60,000 per lot, while a building construction company paid $75,000 for a 12-month option to acquire the remaining 50 blocks. The building construction company exercised its option in Oxford University Press Sample Chapter Capital Gains 35 Australian Taxation Study Manual ¶10-070 September 1993 and paid $3,000,000 for its 50 lots. Legal and other costs in disposing of land averaged $2,100 per lot.

To ensure that only quality houses were constructed on this land, Leman Pty Ltd required each purchaser to sign an agreement which bound the purchaser to ensure that the house constructed would not be two-storey and would be at least 15 squares in area.

The agreement required each purchaser to pay $75,000 to Leman Pty Ltd if the agreement was breached. In July 2017, Fred’s marriage of 20 years ended when his wife filed for divorce. The divorce cost Fred $1,700,000 in an out-of-court settlement. In order to raise these funds, Fred had to dispose of several of his assets.

First, in August 2017, Fred disposed of half his 50% share in The Golden Arms

Hotel for $1,200,000. Under the terms of his disposal, the incoming partner (Mary

Brown) paid Fred $1,200,000 and in return acquired a 25% interest in the business (half of Fred’s 50% interest in the partnership). The purchase agreement contained the following information:

Business land and buildings 650,000

Goodwill 350,000*

Fixtures and fittings 105,000

Trading stock 95,000

$1,200,000 * The value of the goodwill was determined as 70% site goodwill (licence to sell alcohol) and 30% personal goodwill.

Second, in December 2017, Fred disposed of his collection of Australian wildlife paintings. The collection was valued at $350,000 if sold at auction, but as Fred wished to keep the collection in the family, he sold it to his brother Bill for $310,000. Fred had purchased the collection in March 1995 for $120,000.

Discuss the tax implications for Fred Leman, Bill Leman, and Leman Pty Ltd that resulted from each of the above events. In each case you must identify the statutory provisions involved and any relevant case law. Where appropriate, calculations should be provided to support the conclusions from your analysis. Where more than one outcome is possible, state what assumptions you have made and what further information you would require in order to come to a sound conclusion.

Answer

Question 1: Rental expenses:

Legal provisions:

As per the income tax assessment act 1997, the Australian tax officer states that the expenses related to residential property can be claimed as deductions from the taxable income when the house is used for rental purposes. However, the expenses are allowed on a payment basis as the owner is required to pay the expenses related to management/maintenance costs, borrowing expenses, and depreciation. The expenses are allowed under the income tax are as follows (Lee, 2018).

Advertisement expenses for new tenants
Bank charges of the loan
Interest expenses incurred on the loan amount
Loan establishment fees
Housing loan insurance expenses
Corporate fees and clearing cost related to property
Legal expenses and tax related to property
Repair and maintenance
Depreciation on newly purchased items such as furniture, water system, appliance, etc.
Stamp duty charged on the mortgage of property.

The expenses are not allowed as a deduction from the taxable income from house property as per ITAA, 1997 as follows (Lee, 2018).

The acquisition and disposal cost of property
Expenses that are not incurred by the owner such as expenses that are incurred by the tenant.
Stamp duty on the transfer of the property

Application of provisions:

Based on the above discussion, the following expenses are allowed as a deduction to Mr. Kim for the financial year 2018-19:

1. Interest expenses of $ 28000 paid on loan taken for the purchase of house property.

2. Legal fees, loan charges, and stamp duty on the loan paid by Mr. Kim of $ 10000.

3. Repaint of the bedroom of $ 1200 incurred as of 15^th April 2019.

4. Replacement of timber floor with the concrete floor as on 01^st April 2019 of $ 4000 is part of repair and maintenance (Grant, & De Zwaan, 2018).

5. Depreciation on the gas heater which is purchased as of 18^th June 2019 of $ 5200. The depreciation amount will be (5200/10)*13/365 = $ 18.53.

The expenses not allowed as a deduction from taxable income to Mr. Kim for the financial year 2018-19 are:

The expenses incurred at the time of purchase for the roof of $ 22000 as the expense incurred for the roof is part of the cost of the property.

The taxable income of Mr. Kin for the financial year 2018-19 are as follows:

Particulars	Amount
Rental income for the year 2018-19 (700*28)	19600
Less: Interest expenses on the loan	(28000)
Less: Legal fees and stamp duty	(10000)
Less: Repainting of bedroom	(1200)
Less: Floor repair	(4000)
Less: Depreciation gas heater	(18.53)
Net loss on rental house property	(23618.53)

(Blissenden, 2017).

Question 2: Taxable income of Jenny:

Calculation of taxable income for the year ended 30^th June 2020:

Particulars	Amount
Income earned from consulting business ($ 110000 +$ 30000)	$ 140000
Less: Rates related to rooms used for business ($ 3000 * 2 / 6)	($ 1000)
Less: Interest on Mortgage ($ 24500 * 2/6)	($ 8167)
Less: Insurance	($ 1250)
Less: Utilities	($ 4500)
Less: Salaries	($ 15000)
Less: Local Advertising	($ 2400)
Less: Car Expenses ($ 24000 * 0.60 + $ 5800 * 0.60)	($ 17880)
Net Taxable income of Jenny Jones	$ 89803

It is deemed that there is no depreciation charged on computers, printers, and desks as the expense incurred on them are capital nature therefore no deduction is allowed for the whole amount.
The assessable income is the income earned by the taxpayer during the year. It is not related to the contract made by the taxpayer as in this case, Jenny made the contract of $ 150000 with the Victoria Government however the company has not earned the same during the year.
The deductions are allowed for the expenses incurred by the taxpayer for earning the income. In this case, the taxpayer has used 2 rooms of his house for business purposes therefore the expenses related to these rooms are allowed as deductions from income earned.

Alienation of income:

As per ITAA 1997, the alienation of income case arises when the taxpayer forms a partnership firm or company for diluting the tax liability or reduce the tax burden. In this case, there is also the alienation of income. However as per taxation law, if the taxpayer operates a personal service business through a company and there is no income splitting and profits are not retained in the company then the provisions of alienation of income do not apply. In this case, if the profits are not retained to the company then there is not the alienation of income and provisions will not apply to Jenny Jones. However, if the tax benefits are taken by Jenny Jones then the provisions will apply, and tax liability increase as the total profits earned by the company (Blissenden, 2017).

Question 3: Tax implication for capital gain

The fact of the case:

The Golden Arms Hotel that is acquired by the father of Bill and Fred in 1976 at the cost of $ 600000 and $ 120000 for hotel licenses. He had paid $ 150000 in June 1989 to increase the size of the hotel.
The hotel is operated by Bill and Fred as a partnership in which both have equal interest.
The 50 hectares of land on the Mornington Peninsula had acquired by their father in November 1989 for $ 1500000.
The land is transferred to the company formed by Bill and Fred having the name Leman Pty Ltd and they have taken 1500000 non-redeemable ordinary shares paid up to $ 1.50 each.
The cost incurred for the construction of 100 half-hectare lots with the cost of $ 300000.
In Aug 2017 Fred has disposed of half of his share in Leman Ltd for $ 1200000 and the Australian wildlife painting collection for $ 310000 which is purchased in March 1995 for $ 120000 (Grant, & De Zwaan, 2018).

Capital gain on Golden Arms Hotel:

Legal provisions:

As per the income tax assessment act 1997 and ITAA 1936, the partnership firm has no existence as an entity and the liability of income earned through the partnership is part of partners' income based on their sharing of interest. The transfer of a hotel to a partnership firm that has no legal existence is not covered as capital asset transfer, therefore there is no capital gain tax implication in the case of asset hold in the form of the partnership firm.

Applicability of the provision:

Based on the above fact, the Golden Arms Hotel hold by Bill and Fred in equal portion by forming the partnership firm does not incur the liability of capital gain. As the Golden Arms Hotel, licenses, and extension area is purchased by their father and the capital gain event arises when the asset is transferred from their sons to another separate entity or person. Here the partnership firm is not a legal entity therefore there is no capital gain on holding of assets by both brothers. However, the income earned from the business of hotel is taxable in their hand in equal ratio (Killaly, 2017).

Capital gain on land on the Mornington Peninsula:

Legal provisions:

The capital gain event arises when the assets are transferred by the taxpayer to a legal entity. The company has a separate legal entity from the shareholders. The assets transferred to the company against the shares in the company are liable for the capital gain tax (Kasser-Tee, ).

Applicability of provision:

There is the capital gain tax is applicable on the transfer of the land from Bill and Fred to the company and the sales consideration is taken as the market value of the land on the date of transfer as the land is held by both brothers through Lemon Pty Ltd (McKerchar, 2015).

The capital gain tax on land is as follows:

Particulars	Amount
Sales consideration (Market value of land as of June 1991)	$3000000
Less: Cost of acquisition (Amount paid as on Nov 1986)	($1500000)
Capital gain on transfer	$ 1500000
Discounted capital gain on land ($ 1500000 * 0.50)	$ 750000
Capital gain taxable to each brother	$ 375000

Capital gain on a lot of 100 half-hectare:

There is the case of transfer of property as the house is sold by the company after construction on the land. In that case, the cost of acquisition of land is the market value of land i.e. $ 3000000 and the cost of construction is $ 300000 and the sales consideration will be the sale price of lots:

Particulars	Amount
Sales consideration of lots ($ 60000 * 50 + $ 75000 * 50)	$ 6750000
Less: Sales expenses in form of legal and other costs ($ 2100 * 100)	($ 210000)
Net sales consideration of lots	$ 6540000
Less: Cost of acquisition of land	($ 3000000)
Less: Cost of construction	($ 300000)
Capital gain on sale of the lot of 100 half-hectare	$ 3240000
Discounted Capital gain ($ 3240000 * 0.67)	$ 2170800

In this case, the capital gain is taxable in the hand of Lemon Pty Ltd as the company is a legal entity and has a separate taxation obligation under ITAA 1997 and ITAA 1936 (Barkoczy, 2017).

Tax implication in the case of Fred Leman:

Mr. Fred has the following tax implication in the given case:

He is liable to pay tax on the income earned from the Golden Arms Hotel as the partnership firm is not a legal entity and the income is taxable in hands of partners in an equal ratio.
He is liable to pay tax liability on the capital gain to arise from the transfer of land to the company whether the brothers are shareholders or not. The company has a separate legal entity and has separate tax obligations. Mr. Fred is liable for the tax on the capital gain of $ 375000.
The capital gain arises on the sale of lots is not a capital gain obligation for the shareholders. Therefore Mr. Fred is not liable for the capital gain to arise on lots of 100 half hectares (Smith, & Richardson, 2011).
Mr. Fred has sold half of his share in the Golden Arms Hotel during the year 2017. The sales consideration for the same is $ 1200000. The capital gain arising in the hand of Mr. Fred is as follows:

Particulars	Amount
Sales Consideration on sale of a share in Golden Arms Hotel	$ 1200000
Less: Cost of Golden Arms Hotel up to 25% (600000 +120000 + 150000) *0.25	($ 217500)
Capital gain on sale of a share in Golden Arms Hotel	$ 982500
Discounted Capital gain liable for tax ($ 982500 * 0.50)	$ 491250

Mr. Fred is also liable for tax on the sale of the collection of wildlife paintings as the collectible is liable for capital gain tax if the cost of acquisition is more than $ 300. In this case, the capital gain on wildlife painting is covered as collectibles (Burkhauser, Hahn, & Wilkins, 2015).

Particulars	Amount
Sales Consideration on sale	$ 310000
Less: Cost of acquisition	($ 120000)
Capital gain on sale of paintings	$ 190000
Discounted Capital gain liable for tax ($ 190000 * 0.50)	$ 95000

Tax implication on Mr. Bill:

Mr. Bill is having the following tax implications:

He is liable to pay tax on the income earned from the Golden Arms Hotel as the partnership firm is not a legal entity and the income is taxable in hands of partners in an equal ratio.
He is liable to pay tax liability on the capital gain to arise from the transfer of land to the company whether the brothers are shareholders or not. The company has a separate legal entity and has separate tax obligations (James, & Wallschutzky, 2017).Mr. Bill is liable for the tax on the capital gain of $ 375000.
The capital gain arises on the sale of lots is not a capital gain obligation for the shareholders. Therefore Mr. Bill is not liable for the capital gain to arise on lots of 100 half hectares.

Tax implication on Lemon Pty Ltd:

The company is liable to pay tax on the capital gain arise from the sale of lots of 100 half hectares as the company is a separate legal entity and liable for the tax on capital gain arise from the sale of lots.

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