Edited version of private ruling

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Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for the full amount of interest incurred on your loan?

Answer

No.

Relevant facts and circumstances

You purchased property 2. A portion of the purchase price was funded by a loan from a bank.

You purchased this property intending for it to become your main residence. However, as you had not sold your current residence (property 1), you rented property 2 from the time of purchase until property 1 was sold.

You also purchased an investment property (property 3). You funded part of the purchase price through the same loan facility as property 2.

You sold property 1. Property 2 then became your main residence.

You applied the proceeds from the sale of property 1 to reduce your loan.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. To determine whether the associated interest expenses are deductible under section 8-1 of the ITAA 1997, TR 95/25 specifies that it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will be deductible.

Taxation Ruling TR 2000/2 considers the operation of section 8-1 of the ITAA 1997 where the borrowed money has been applied for both income producing and non-income producing purposes.

Repayments

All repayments made from the date that the loan was established must be notionally apportioned (see paragraphs 44-46 of TR 2000/2). In regards to repayments to the loan facility, paragraph 44 specifically states:

The balance outstanding on a mixed purpose line of credit sub-account or a mixed purpose loan account is an undivided single debt owed by the borrower to the lender. When repayments of principal are made, it is not considered possible to direct those   payments to only that part of the borrowed funds used for a particular purpose as if it   were a separate debt. While it may be possible to trace the uses to which different parts of the borrowed funds are put, it is considered repayments of principal need to be applied proportionately to reduce the balance of the outstanding principal attributable to income producing use and non-income producing use respectively, e.g., if 70% of an outstanding line of credit sub-account debt is used for income producing purposes, 70% of any repayment would be in respect of that part of the outstanding debt.

One exception to this principle is where money borrowed and applied to a particular use is recouped. This happens when an amount of money is borrowed and used for buying a particular asset and some part of it is recovered; for example on the sale of the asset that had been purchased with the borrowed funds. Where the borrowed funds recouped are paid into a mixed purpose account or sub-account, those funds have ceased to be outstanding funds used for any purpose. The effect of the repayment of the recouped funds to the mixed purpose sub-account is to reduce only that part of the outstanding line of credit debt applied to the previous use of those funds.

In your case, the sale proceeds of property 1 were used to reduce the portion of the loan attributable to property 2. In order for the exception to apply, the borrowings and the money recouped must relate to the same asset. The sale proceeds from property 1 do not relate to the borrowings used to purchase property 2. Therefore, you did not actually recoup the amount borrowed for property 2. The exception would apply if you had sold property 2 and used the proceeds to reduce that portion of the loan that related to that same property.

As this exception does not apply to your circumstances, the proceeds from the sale of property 1 can not be solely applied to the portion of the loan that represents property 2. It is not possible to direct the payment to a part of a loan for a particular purpose. Repayments need to be applied proportionately to reduce the balance of the loan attributable to income producing and non-income producing purposes, respectively.

Property 2 became your main residence at the time you applied the proceeds from the sale of property 1 to reduce the loan. The loan for the two properties should have been reduced proportionately. The borrowed funds in relation to property 2 had a private purpose from that point onwards.

This means that you had a mixed purpose loan, being for property 2 (private use of the funds) and property 3 (income producing use of the funds).

As a part of the loan is used for private purposes, the interest incurred on this portion is not deductible under section 8-1 of the ITAA 1997. That is, the interest incurred on the portion of the loan which is applicable to property 3 is allowable as a deduction.

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