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Ruling

Subject: Rental property - interest expense

Question 1

Will you be entitled to claim the entire amount of interest expense on loan account 1 as a deduction in relation to your rental property?

Answer

No.

Question 2

Will you be entitled to a claim a deduction for a portion of the interest expense on the loan funds used to purchase a property containing two houses, one of which will be rented to an unrelated third party?

Answer

Yes.

This ruling applies for the following periods

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commenced on

1 July 2012

Relevant facts and circumstances

You and your spouse purchased a block of land, jointly, under one title.

The land has two houses on it.

You will live in one of the houses (your private residence) and will rent the other house (the rental property) to an unrelated party at market rates.

You funded the purchase of the property with a loan and your own funds.

Your own funds were sourced from savings and were not from the sale of your previous private residence.

The loan was divided into two loan accounts.

Both loan accounts have an interest only period.

You state that loan account 1 represents the loan funds relating to the purchase of the rental property. You apportioned the loan between the two houses on the basis of their respective floor areas.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You will be entitled to claim a deduction for a portion of the interest expense on the loan funds used to purchase a property containing two houses where one of the houses is rented or available to rent at market rates.

The allocation of the loan funds and amount of deductible interest attributable to the rental property should be determined using a reasonable basis of apportionment.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 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, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

Taxation Ruling TR 95/25 provides that the deductibility of interest is determined by the use to which the borrowed money is intended. The use test is the basic test for the deductibility of interest and looks at the application of borrowed funds as the main criteria. Where the borrowed funds are used for the purposes of producing assessable income, a deduction will be allowed for the interest on the loan. This includes interest on loans used to acquire a rental property.

Where a loan is used to acquire an asset which is used for both income producing and non-income producing purposes, only the portion of the interest expense on the borrowed funds relating to the income producing purpose is deductible.

In your case, you purchased a property on which two houses stand. One house will be used as your private residence and the other will be rented to an unrelated party at market rates.

You will be entitled to a deduction for the interest expense on that portion of the loan which can be attributed to the rental property during the periods where the property is either rented or available for rent.

Determination of the portion of the loan relating to the rental property

As discussed above, only a portion of the loan relates to the rental property. As the rental property and your private residence were purchased as one combined asset, you need to use a reasonable basis to apportion the purchase price between the two houses. This apportionment will then be applied to divide the borrowed funds between the two uses.

Whilst the taxation legislation does not specify the basis of apportionment that should be used, in this situation, the floor area of the houses is generally not considered to be an appropriate method as the physical condition of each house can differ significantly. This method may be appropriate where the physical condition of each house is similar.

An alternative basis of apportionment is the commercial or market value of each property. The valuation need not be a formal quantity surveyor's report but may take the form of valuations from two or more real estate agents.

You advise you determined the portion of the loan relating to the rental property was calculated on the basis that the floor area of the rental property.

The apportionment does not take into account any of your personal savings which were contributed towards the purchase of the entire property. You have 'allocated' these funds against the cost of your private residence.

Taxation Ruling IT 2661 discusses the apportionment of interest where money is borrowed to fund the purchase of an asset part of which is used for a business purpose and part for a non-business purpose.

This issue was considered by the Federal Court of Australia in FC of T v. Carberry 88 ATC 5005; (1988) 20 ATR 151 (Carberry's case). In Carberry's case the taxpayers purchased a property worth $140,000 consisting of a residence and kindergarten in separate buildings. The purchase price included an amount of $20,000 for goodwill, plant and equipment. To fund the purchase of the new property and additional equipment, the taxpayers used funds of $80,000 from the sale of their previous residence and borrowed $68,000 against the purchased property.

Davies J accepted that the $80,000 from the sale of the taxpayers' previous residence was used to purchase the new residence and that the taxpayers contributed $10,000 capital towards the business partnership. Accordingly, his Honour agreed that the borrowings of the $68,000 could be solely attributed to the $70,000 required to purchase the kindergarten premises and the goodwill.

The Commissioner will accept the approach adopted by the Federal Court where

Your situation differs to that in Carberry's case as your personal funds were sourced from savings and not from the sale of your previous residence. You did not use funds sourced from the disposal of an asset to purchase a replacement like asset. Thus, the Commissioner does not consider it appropriate that the full amount of your personal savings is allocated solely to your private residence.

Irrespective of the method used to apportion the purchase price between the two houses, the personal savings used must also be apportioned between them.

To determine your interest deduction, you must:

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