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Edited version of private ruling

Authorisation Number: 1011564860921

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Ruling

Subject: Interest expenses

Question 1

Are you entitled to a deduction for 100% of the interest expenses incurred after refinancing your loans to affect an agreement under the Family Law Act 1975?

Answer

No

Question 2

Are you entitled to a deduction for interest expenses incurred on part of a loan used to pay out your former spouse's share of an investment property?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts and circumstances

You and your former spouse made arrangements to have your joint assets and liabilities divided between yourselves due to a marriage breakdown.

You both entered into an agreement pursuant to Section 90C of the Family Law Act 1975 which required you to discharge joint mortgages and establish new titles and refinance loans. You have provided a copy of the agreement.

The agreement provided that as soon as practical and within 30 days of the agreement the parties contemporaneously do as follows:

Under the signed agreement you would have ownership of the marital home and one of the investment properties and relinquish your claim on any other assets held by your former spouse in order to finalise the agreement outside court.

You have provided copies of your home loan and investment home loan statements with outstanding balances that were held jointly with your former spouse.

You and your former spouse established new loans independently of one another that would void the old debt and be considered as payment to each other for the relevant investment properties.

You established a new loan and paid out your joint home loan and the investment loan on a jointly held rental property.

Your former spouse established a new loan to release you of a joint debt for the other investment property.

The investment properties were settled and no lump sum payments transferred between each other.

You and your spouse have conducted necessary enquiries to inform yourselves of the financial affairs and the current value of assets and liabilities as set out in the attachment of the agreement.

You have provided a copy of loan approval and statement for the new residential investment loan in your name.

Reasons for decision

Summary

You are not entitled to a deduction for 100% of the interest expenses incurred on the new residential investment loan.

However, you are entitled to a deduction for interest expenses incurred for the part of the loan used to pay out your former spouse's share of an investment property.

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.

The general principles relevant to the deductibility of interest expenses are set out in Taxation Ruling TR 95/25. The test is one of characterisation and the essential character of an expense is a question of fact to be determined by reference to all the circumstances.

The character of interest on a loan is generally ascertained by reference to the purpose of the loan (Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 and the use to which the loan is put (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153 (Munro's Case).

The 'use' test, established in Munro's Case, 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 income is to be derived, the interest incurred on the loan will be deductible. 

Further, interest on a new loan used to repay an existing investment loan will generally also be deductible as the character of the new loan is derived from the original borrowing. That is, when a loan is refinanced, the new loan takes on the same character as the previous loan. Refinancing a loan does not in itself break the nexus between the outgoings of interest under a loan and the income earning activities.

You and your former spouse have refinanced your jointly held loans for the marital home and investment properties to affect an agreement under the Family Law Act 1975. In refinancing you established a new residential investment loan in your name to pay out the jointly held home loan and an investment loan.

Thus, part of the funds from your new investment loan has not been used for income producing purposes but to pay out the joint loan on your marital home. Therefore, the interest paid on that part of the new loan will not be deductible under section 8-1 of the ITAA 1997.

However, funds used from the new loan to pay out your former spouse's share of the investment property were used for purchasing an income producing asset. Accordingly, interest expenses incurred on that portion of the loan is deductible under section 8-1 of the ITAA 1997.

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