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Edited version of private ruling
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Ruling
Subject: Interest on rental property loan
Question:
Will you be entitled to claim deductible interest on a loan to purchase your spouse's 50% share of a property?
Answer: Yes
This ruling applies for the following period
Year ending 30 June 2011
The scheme commenced on
1 July 2010
Relevant facts
You and your spouse jointly own the home you both have lived in since purchase. Your spouse owns another property in their own name. Your spouse's property has been a rental property for several years, and has now been demolished, with a new property under construction which will be your new principal place of residence.
You wish to buy your spouse's 50% share of the current family home, and eventually use it as a rental property.
You would borrow half of the current valuation of the property in order to purchase your spouse's share. You state that your main reason for doing this is for each partner in the marriage to have one property in their name.
The 50% share of the property would be sold to you at market value at the same price as if it were purchased by a non-related third person.
Reasons for decision
Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses or 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 in nature or are necessarily incurred in gaining or producing exempt income.
The general principles relevant to the deductibility of interest expense are set out in Taxation Ruling TR 95/25. This Ruling provides that interest expense is incurred in gaining or producing assessable income and is not of a capital, private or domestic nature if it has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income. 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 see 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 see Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153. Therefore, if a loan is used to purchase property from which income is to be derived, the interest paid on the loan is generally deductible.
Taxation Ruling TR 95/33 requires an examination of all the circumstances surrounding the expenditure to ensure that the interest expense could be properly characterised as genuinely, and not colourably, incurred in gaining or producing the assessable income.
The Commissioner considers that the purchase of a share of a property at market value from one spouse to another spouse does not necessarily create a situation where the transaction is considered to be solely for a tax benefit.
In your case, you intend to use a loan to purchase your spouses share of the property at market value for the future purpose of deriving rental income.
A practical weighing of all of the factors could be expected to lead to the conclusion that the relevant interest expense is properly to be characterised as genuinely, and not colourably, incurred in gaining or producing assessable income.
Therefore, you are entitled to a deduction, under section 8-1 of the ITAA 1997, for the interest payments on a loan, where the proceeds of the loan will be used to purchase your spouse's property, at market value, for the purpose of deriving rental income.
It should be noted that while you continue to live in the present family home, the interest incurred on your loan to purchase your spouse's share is deemed to private or domestic in nature, and as such no deduction may be claimed until the property is made available for rent.
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