Edited version of private ruling

Authorisation Number: 1011826123283

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Ruling

Subject: Deduction for interest expenses

Question

Are you entitled to a deduction for 100% of the interest expense relating to a refinanced loan in your name for your jointly owned investment property?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts

You and a family member purchased an investment property as joint owners.

You and your family member borrowed funds on a fixed interest loan to purchase the property.

The joint loan reverted to a variable loan with principle and interest repayments.

You and the family member (person A and person B) made repayments of interest and principle of the loan.

The loan balance has been reduced.

You are intending to re-structure your current loan held with a financial institution into two separate loans by refinancing the loan balance.

Person A intends borrowing amount X equal to half the outstanding amount from a financial institution (Loan A).

Loan A will be a principle and interest loan.

Person B intends borrowing an equal amount from a financial institution (Loan B).

Loan B will be an interest only loan.

Person A intends to repay your loan in a few years time.

Person B intends to make repayments of interest only on loan B.

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 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Where borrowing is used to acquire an income producing asset, the interest on this borrowing is considered to be incurred in the course of producing assessable income.

In examining the use of borrowings, there may be instances where the loan has a mixed purpose. Where there is a mixed purpose, only the interest of the portion of the borrowing which is attributed to an income producing purpose is 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.

In your case, the loan balance on the original funds used to purchase to the property has been reduced. You intend to restructure your existing joint loan and take out separate loans with a financial institution to refinance your investment property. When you refinance your loan the borrowed funds are still being used for income producing purposes.

Loan in separate names but the investment property held in joint names

Taxation Ruling TR 93/32 examines the taxation position of co-owners of a rental property whose activities do not amount to the carrying on of a business.

TR 93/32 states that the co-ownership of rental property is a partnership for income tax purposes but is not a partnership at general law unless the ownership amounts to the carrying on of a business. Generally, where co-ownership is a partnership for income tax purposes only, the income/loss from the rental property is derived from co-ownership of the property and not from the distribution of partnership profits/losses. Accordingly, the income/loss from the rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title.

Partnership at general law

The primary factor in the definition of a partnership in general law is "carrying on a business". If you are not carrying on a business you cannot be a partnership at general law. Paragraph 5 if Taxation Ruling IT 2423 states:

An individual who derives income from the rent of one or two residential properties would not normally be thought of as carrying on a business. On the other hand if rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business.

You and your family member are the co-owners of one investment property. You are not carrying on a business. You are not partners at general law.

Partnership for income tax purposes

The definition of partnership is wider for income tax purposes than it is at general law. Under the income tax definition, you and your spouse are a partnership in respect of the rental property. Paragraph 25 of TR 93/32 states:

Under the extended income tax definition of partnership, it is not necessary that persons carry on a business for their association to be treated as a partnership for income tax purposes. They need only be in receipt of income jointly. Therefore, co-owners of rental property come within the definition of "partnership" for income tax purposes, not because they are necessarily partners at general law, but because they are in receipt of income jointly.

As you are not involved in a partnership at general law, the income/loss must be shared according to the legal interest of the property.

The deductibility of interest was further examined in Case 63/96 96 ATC 578, where a loan was taken out solely in the taxpayer's name to refinance joint borrowings in a rental property. It was determined that the interest on the refinanced loan was an expense of the joint owners in deriving the rental income, rather than an expense of deriving the taxpayer's interest in the net income from the joint ownership. Therefore, it was to be taken into account in arriving at the net income of the partnership. This would effectively mean that interest was claimable equally between the partners.

However, although the final decision in the above case was that the interest was to be shared equally, B. H. Pascoe, Senior Member, also stated:

...For example, it would seem that where two people agree to jointly purchase a property for rental purposes and one borrows money solely for the purpose of contributing his or her share of the purchase price, then the interest on that borrowing would be an expense of the borrower and deductible from his or her share of the net rental income. It would not be appropriate that such interest be required to be taken into account in arriving at the net income of the partnership. On the other hand where the parties jointly incur an expense related to the property as a whole such as rates, insurance and interest on borrowings to fund the joint equity, such expenses must be taken into account in arriving at the net income of the partnership notwithstanding that the payment of the expense was made by one of the partners only...

In your case, the refinancing of your previously joint borrowing into separate loans does not change the character or the deductible portion of the interest expense. That is, you jointly still incur the expenses on the two new loans even though they are held in one name only. Therefore you are not entitled to a deduction for a 100% of the interest expenses incurred on the refinanced loan held in your name as the legal title of your property shows that you and a family member are joint tenants, and as discussed above, the net income or loss from an investment property is distributed according to legal title. You are only entitled to claim 50% of the interest expense in relation to the refinanced loans on your investment property.

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