Edited version of private ruling

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Ruling

Subject: Rental property interest on loan from spouse deductibility

Question 1

Are you entitled to claim a deduction for interest incurred on a loan from your spouse used to purchase a rental property?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You plan to buy a house.

You plan to rent the house out.

Your spouse has the required amount to buy the house in their bank account and has agreed to loan you that amount.

The house will be solely in your name.

You and your spouse will sign a mortgage agreement for the loan.

You have not recently deposited money into your spouse's bank account that they are now going to lend to you.

The money in your spouse's account has come from money they earn and shares they cashed in years ago.

Your repayments on the loan will be at a fixed interest rate in line with the major banks.

The repayments on the loan will be interest only for 5 years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

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. Interest is not deductible to the extent that the expense is of a capital, private or domestic nature.

Taxation Ruling TR 95/25 provides the following general principles when determining whether an interest expense meets the requirements of section 8-1 of the ITAA 1997 and is therefore deductible:

The interest expense must have a sufficient connection with the operations or activities, which more directly gain or produce your assessable income. In other words, it must have the essential character of an income producing expense as opposed to a capital, private or domestic expense; and

The character of interest on money borrowed is generally ascertained by reference to the objective purpose or use to which the borrowed funds are put by the borrower. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding whether the interest is deductible

The primary test of deductibility of interest is determined by examining the purpose of the loan and the use to which the loan is put. This 'use' test, established in FC of T 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 on borrowed monies used in financing the purchase of a residential property is not deductible when the property is used as a private residence. This is because the property is not an income-producing asset. The interest incurred will be deductible to the extent that the property is used to produce assessable income or is available to produce assessable income. If a property was used partly to produce rental income and partly as the taxpayer's residence, only part of the interest would be deductible.

However, interest may not be deductible either in full or part where non-commercial terms apply (for example, interest rate payable on a loan is greatly above or below the market rate). Where a property produces income or losses on arm's length terms, interest will generally be deductible even if it exceeds the income produced.

In your case, you will borrow money from your spouse for the purpose of buying an investment property which will be rented out. On the face of it, the interest expense you have described will meet the tests of deductibility. That is, it will be incurred for the purposes of deriving assessable income and will not be for reasons of a private, domestic or capital nature. The rate of interest that you will incur on this loan from your spouse will be set using commercial interest rates as guidance. As such, the interest incurred on the loan from your spouse will be deductible as we are satisfied that the loan is a commercial arm's length arrangement.

Additional information

Please ensure that a commercial loan exists and that it has been made at arms length. To this end it is recommended that the setting up and servicing of the loan should be thoroughly documented as follows:

Loan set-up - the documentation should enable a trail of the monies from your spouse to yourself to be followed. The money used to finance the rental property should be able to be clearly traced back to your spouses' bank account to you. The documentation should be able to clearly show that the purchase of the property is not wholly from non-borrowed sources, such as your own savings.  A loan agreement, setting out the terms and conditions of the loan and repayment requirements would assist also.

Servicing - documentation should exist to clearly show that you are servicing the loan.  This will distinguish the proposed transaction from that of a gift from your spouse.  Receipts issued to you, signed by your spouse, and account statements or deposit slips into your spouses' accounts would be useful.

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