Edited version of private ruling

Authorisation Number: 1011587438607

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Ruling

Subject: Interest expenses - rental property off the plan

In the situation (due to ordinary financial obligations) where you have an economic inability to repay your loan in full, can you claim deductions in relation to interest incurred on this loan where the funds were borrowed to purchase a rental property off the plan?

Yes.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You paid a 10% deposit for an investment property off the plan. This deposit was financed by your existing home loan. Soon after, the developer went into liquidation. The property had a conditional lease attached to it for rent to a government housing scheme.

At this time, you are unsure about whether you will receive any funds from the liquidator. As you have a large mortgage on your primary residence and as you and your spouse earn average incomes, you do not have any available cash to repay the loan in full.

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.

Taxation Ruling TR 2004/4 allows deductions for interest expenses incurred prior to the commencement of relevant income earning activities. It also allows deductions for interest expenses following the cessation of relevant income earning activities when a taxpayer can demonstrate a legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

Regarding the phrase 'economic inability to repay', this means where a taxpayer does not have an excess of funds beyond those required for their basic living expenses. The outstanding loan must have the character of a continuing obligation that is a burdensome legacy of the past.

For example, TR 2004/4 states where there are sufficient funds held in a bank account that could easily be used to repay the loan principal or where the proceeds from the sale of assets purchased with the loan are used to purchase a leisure yacht, the refusal to repay the loan suggests the loan is being kept on foot for reasons other than the former income earning activities. In such cases, the nexus between the borrowings and the relevant income earning activities will be broken and the relevant interest expenses will not be deductible.

On the other hand, if a taxpayer sells their primary residence and uses the proceeds from the sale to purchase another residence closer to a new place of employment, this would not have the effect of breaking the nexus between to borrowings and the former income earning activities. In such a case, the relevant interest expenses will continue to be deductible.

These guidelines in TR 2004/4 follow the decision in the Full Federal Court case of Federal Commissioner of Taxation v. Jones (2002) 117 FCR 95; 2002 ATC 4135; (2002) 49 ATR 188 (Jones). In this case, the taxpayer and her husband had conducted a trucking and equipment hire business in partnership since 1967. In 1992, the taxpayer's husband died. Despite efforts to sell the partnership assets to clear as much debt as possible, the taxpayer was faced with a net debt from an ANZ loan of around $80,000. In 1994, the taxpayer recommenced full time employment as a nurse and used more than half of her after tax salary to repay the loan. In May 1996, the taxpayer refinanced the loan through RAMS to obtain a lower interest rate. After paying out the ANZ loan, the taxpayer owed about $74,000 to RAMS. The Court held the relevant interest expenses were deductible because the taxpayer had no free choice between continuing the loan and repaying it. The failure to repay the loan over the lengthy period since her husband's death was attributable to her financial position and not to any decision to keep the loan on foot for other reasons.

In your case, the conditional lease agreement demonstrates you intended to purchase the property for the purpose of earning assessable (rental) income. It follows there is a nexus between your current incurring of the interest expenses and the gaining or producing of assessable income. As your current financial situation creates an economic inability to repay the loan in full, you are eligible to claim deductions for the relevant income expenses as long as this economic inability to repay the loan in full remains. If you receive any return of funds from the liquidator, the decision in the case of Jones suggests you should apply such funds to your loan principal. If you do not apply such funds to the loan principal, the nexus between the relevant interest expenses and the former income earning activity may be broken and the relevant interest expense may cease to be deductible.

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