Edited version of private ruling

Authorisation Number: 1011540079135

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Deductions - interest

Questions and answers:

Are you entitled to deductions for interest on a loan initially taken out to assist with the purchase of a rental property that has become your main residence?

No.

Are you entitled to deductions for interest on a loan taken out to refinance a loan that was formerly associated with the acquisition of an income producing property that has become your main residence?

No.

This ruling applies for the following period:

1 July 2009 to 30 June 2010.

The scheme commenced on:

1 July 2009.

Relevant facts:

You purchased an investment property (property one).

You took out a loan (loan one) to assist with your purchase of property one.

Property one was used as security against loan one.

You used property one to produce assessable income by renting it out for a period of time.

Property one later became your principal place of residence and you purchased another investment property (property two).

You took out a new loan (loan two) to fund your acquisition of property two.

Properties one and two were used as security for loans one and two.

Property two is tenanted.

You have stated that if you cannot claim deductions for interest on loan one from the time you acquired property two, you intend to pay loan one out by taking out another loan (loan three) in the same amount as loan one which you will use solely to fund property two.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Deductions for interest on residential properties where the 'use' of the property changes from income producing to private and domestic

Interest is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature.

Taxation Ruling 95/25 (TR 95/25) contains the Australian Taxation Office view on when interest is deductible under the provisions of section 8-1 of the ITAA 1997 and specifies there must be a sufficient connection between the interest expense and the activities which produce assessable income for a deduction to be allowed.

The 'use' test (established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153) is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Interest will be deductible to the extent that the funds are used to produce assessable income.

When a taxpayer borrows money to acquire a rental property used to produce assessable income, there is a sufficient connection between the expense and the production of assessable income for the interest on the borrowed money to be deductible.

However, if there is a change in the use of a property from income producing to private and domestic, the necessary connection between the interest expense on funds borrowed to acquire the property in the first place and the production of assessable income is broken. In circumstances such as this, the use of the borrowed funds change from income producing to private and domestic in line with the change in use of the property. Deductions for interest cease to be available when this happens.

In your case you took out loan one to assist with your acquisition of property one.

Initially, you used property one to produce income by renting it out, however, property one later became your principal place of residence.

From the time you occupied property one as your principal place of residence, your use of property one and loan one changed from income producing to private and domestic and you ceased to be entitled to any deductions for interest on loan one.

Use of properties as security for a loan does not determine the 'use' of the loan for income tax purposes

The use of a residential property to provide security for a loan (by way of a registered mortgage for example) is irrelevant in determining whether or not the borrowed funds are being used for income producing purposes.

For example, a home owner who might already have a mortgage over the family home, might borrow money to acquire a rental property. In such cases it is not uncommon for both properties to be used by the lending institutions as security for both loans.

In these situations, the use of the family home as security over the newly acquired rental property does not change the use of the family home, nor the loan used to initially acquire it, to income producing. Rather, the use of the family home remains private and domestic, as does the use of the funds borrowed to acquire the family home. Regardless of the fact that the family home is used as security for the rental property, no deductions are available against the family home.

In your case, the purpose of loan one was, and remains, the acquisition of property one. The fact that properties one and two are now both used as security for loan one does not change the fact that your use of loan one became private and domestic, and your entitlement to deductions for interest against loan one ceased, when you commenced occupying property one as your principal place of residence.

Deductibility of interest on a borrowing used to refinance an existing loan that is not being used for income producing purposes

In relation to the deductibility of interest on a borrowing used to refinance an existing loan, paragraph 42 of TR 95/25 specifies that:

Interest on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income producing activity….

In your case, loan one is no longer being used by you in an income producing activity. As stated above, the use of loan one is now private and domestic and you are no longer entitled to deductions for interest against loan one. Any subsequent refinancing of loan one will be considered a refinance of a non-income producing loan and no deductions for interest will be available against the new loan.

This will be the case regardless of whether or not you put funds acquired by refinancing loan one to use in property two. Although property two is income producing, it is the use of the funds at the time of the refinancing that determines the income tax treatment of the funds acquired by the refinancing.

Conclusion

From the time you commenced occupying property one as your principal place of residence, your use of property one changed from income producing to private and domestic. Your entitlement to deductions for interest against loan one ceased from that point forward because loan one was no longer associated with an income producing activity.

This change in the use of loan one from income producing to private and domestic use is not affected by your use of an income producing property (property two) as security for loan one.

It is not the nature of assets used as security for a loan that determines whether a deduction for interest will be available against the loan. What is relevant in determining whether such deductions will be allowed is the purpose and use of the loan.

In your case, the purpose and use of loan one was, and remains, the acquisition of property one which you are now occupying as your principal place of residence.

Any subsequent refinancing of loan one will be considered a refinance of a loan that is not being used in an income producing activity and no deductions for interest will be available against any funds obtained by refinancing loan one.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).