Edited version of private ruling

Authorisation Number: 1011552904712

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Ruling

Subject: Interest expense

Question 1

Are you entitled to allocate all proceeds from the sale of an investment property to your private assets where the funds have been deposited into a mixed purpose loan?

Answer

No.

Question 2

Is apportionment of your interest expense for a mixed purpose loan based on the annual council valuations of your properties considered to be a fair and reasonable apportionment for taxation purposes?

Answer

No.

Question 3

Are you entitled to claim a deduction for the total interest expense on a mixed purpose loan?

Answer

No.

Question 4

Are you entitled to a deduction for the portion of interest expense relating to the borrowed funds remaining on your investment property?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

Year ending 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commenced on

I July 2006

Relevant facts

You purchased a property (unit 1) as your main residence several years ago using borrowed funds.

Not long after you purchased unit 1, you constructed another building (unit 2) on that property using borrowed funds. You consolidated the loans for units 1 and 2 into one home loan.

You then used unit 2 as your main residence and unit 1 as a rental property.

Some years later you purchased another property to use as your main residence. You borrowed the full purchase price.

You refinanced your existing loan. The new loan included the outstanding amount owing on units 1 and 2, an amount for your private purposes and the full purchase price for your current main residence. Again this was one combined loan.

You then used units 1 and 2 as rental properties.

You then sold unit 2 a short time after it became a rental property and used those funds to reduce the loan.

You have also redrawn funds for private use which you have since repaid. You applied the repaid funds to the redrawn funds when apportioning the interest expense.

You alter the apportionment of the interest on your combined loan each year based on the latest council valuation of the properties.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision

Summary

All funds paid into your mixed purpose loan apply to the total debt except for the traceable portion outstanding for unit 2 as that asset ceased to exist. You are not entitled to allocate them solely to your private assets or funds redrawn for your private use.

There needs to be a tracing of the use of the funds, and an apportionment of interest based on the valuation of the properties each year is not considered to be a fair and equitable apportionment.

Detailed reasoning

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.

Taxation Ruling TR 95/25 deals with the general principles governing deductibility of interest under section 8-1 of the ITAA 1997.

To establish that there is a sufficient connection between incurring an interest expense and the gaining or producing of assessable income, regard must be given to all the circumstances including the use to which the borrowed funds are put.

Use test

The 'use' test, established in FC of T v Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks to the application of the borrowed funds as the main criteria. Where borrowed funds are used for private purposes, such as the acquisition of a home, the interest will not be deductible even if there is a secondary result that other assets are able to be retained for the purpose of producing assessable income.

The 'use' test was relied upon by the Board of Review in its decision of Case B11, 70 ATC 46 (Case B11). In that case, the taxpayer purchased a new home with borrowed monies, having decided to retain ownership of his former home with a view to leasing it. The former home was let to a tenant for a term commencing at about the same time that the taxpayer vacated it and took up residence in his new home. The taxpayer's claim for a deduction against the rent received for the interest paid on the borrowed monies was disallowed. It was held that the borrowed monies not only enabled the taxpayer to retain his former home for income-producing purposes but also to acquire ownership of a new house as a family residence. Although it would not have been possible to achieve both these results without borrowing, no apportionment of the interest paid is possible as the deductibility of interest depends directly and only on the use to which the principal is put.

In your case, you have a mixed purpose loan. We acknowledge that the valuations of your property change each year. However this has no effect on your interest deduction for taxation purposes. It is the use of the borrowed finds that are relevant.

You are not entitled to use a different annual valuation each year to apportion the interest expense. You are only entitled to claim a deduction for the interest incurred on the funds which were used for your income producing assets, that is, the purchase of unit 1.

Refinancing an investment loan

Where an original borrowing is refinanced, the new loan takes on the same characteristics as the original borrowing. If a deductible borrowing is refinanced, the interest on the new loan will generally be deductible. If only part of the original borrowing was used for income producing purpose then the percentage of the loan attributable to the income producing purpose is carried forward to the new loan. For example if only 80% of the original loan was used for income producing purposes then if the new loan is used solely to refinance the original loan then only 80% of the new loan will take on the income producing characteristic. In this case only 80% of the interest applied to the new refinanced loan will be deductible.

TR 95/25 stipulates that interest accrued on a loan with redraw facilities is to be apportioned to the extent that it is incurred on borrowings that are used for income producing purposes. A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity.

You had a combined loan for both units. The remainder of the loan was for private use. The borrowed money that relates to the income producing activity should be able to be traced. Using annual valuations of the assets may show you the current worth of your assets but does not show a tracing of the borrowed money.

Payments to the line of credit facility

Taxation Ruling TR 2000/2 provides the Australian Taxation Office (ATO) view on the deductibility of interest on money drawn down on a loan with redraw facilities. In this ruling the Commissioner has acknowledged that an alternative view has been suggested that funds redrawn funds from a loan account which can be attributed to the extra repayments made, simply represent a withdrawal of funds temporarily 'parked in the loan'. This alternative view is based upon a characterisation of the extra repayments as effectively remaining an asset of the borrower, available to the borrower by virtue of the contractual right to redraw them.

The ruling goes on to explain that this view is not correct (paragraph 49). The extra repayments have been used to discharge part of the loan debt and the subsequent redraw is funded by a subsequent increasing of the loan debt. In the ATO view, the redraw is a new borrowing of money.

When a payment is made into a your line of credit facility this represents a repayment in relation to the total existing debt of your line of credit facility and not just the personal debt portion. Therefore, you will need to apportion any existing interest deductions into non income purpose and income producing purposes on the balance of the loan at the time of making the payment as the line of credit facility is a mixed purpose account.

However, there is an exception where money borrowed and applied to a particular use is recouped (i.e. on the sale of an asset which was purchased with the borrowed funds) that part of the outstanding balance of the mixed purpose debt can no longer be regarded as applied to that use. Where the borrowed funds recouped are paid into the mixed purpose loan 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 loan is to reduce only that part of the outstanding line of credit debt applied to the previous use of those funds.

You sold unit 2 which was funded by part of the borrowed funds. The proceeds would firstly be applied to any outstanding balance on unit 2. Then the remainder can not be apportioned to only part of the remaining debt but relates to the total debt. For example, if X% of your loan is for income producing purposes and Y% is for private purposes, any repayments are made in the same proportions, that is X% of repayments reduce the income producing portion and Y% of repayments reduce the private portion.

You have also withdrawn funds for private use and used funds to purchase your private car. The same principles apply and any funds paid into the loan relate to the entire debt and not only the private part. That portion of the loan will remain private and the associated interest is not deductible.

Conclusion

In your case it is acknowledged that you have refinanced your loan twice, sold one of the assets, applied the proceeds from the sale to the loan and redrawn funds for private use. However the current valuation of the existing assets does not show a tracing of the funds borrowed for your income producing asset, unit 1.

As explained above any funds deposited into the loan relates to the total debt. The funds or proceeds must be applied to the traceable borrowed funds used for unit 2 as that asset no longer exists. Then any remaining proceeds are to be applied to the total of the remaining loan.

Funds that you have redrawn for private use are new borrowings and money repaid to the loan cannot be applied to only that part of the loan. Any other funds deposited into that loan must be applied to the total loan.

Therefore using the annual valuation to apportion the interest expense is not considered fair and reasonable for tax purposes nor are you entitled to apply the funds deposited into the loan to your private assets and redraws.

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