Edited version of your private ruling

Authorisation Number: 1012536389010

Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for interest expenses on a subsequent loan after the original investment property loan was paid out?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

You have an investment property.

You took out a number of loans in relation to building the investment property.

The security for a loan was your main residence, which was owned outright.

The plan was to consolidate all the loans at the completion of the build which would release your main residence as security.

You decided to sell your main residence. The building of your investment property was not completed at this stage. You could therefore not consolidate your loans as planned.

You repaid one of the loans using the proceeds from the sale of your main residence.

It was a requirement of the bank to discharge the loan when your main residence was sold.

You were at the time purchasing a block of land to build your new main residence, however this was not enough security for the loan.

You attempted to obtain a construction loan for your new residence and re-establish the investment property loan. However the bank required additional income to gain a home loan.

A few months later you were able to obtain a construction loan to build your new main residence. You were able to borrow additional funds. You attempted again to re-establish an investment property loan, but were unable to.

You were able to consolidate some of the loans into one mortgage.

The bank is now willing to loan you further funds as a residential investment loan. This amount would be against your investment property. The money from this loan would be deposited into an offset account and offset your current mortgage on your main residence. You were hoping to return the funds to your original intention of owning your main residence outright with a fully mortgaged investment property.

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 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.

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, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criteria. Where borrowed funds are used for private purposes, such as the acquisition of a home, the interest will not be deductible even if there is a secondary result that other assets are able to be retained for the purpose of producing assessable income. Where a borrowing is used to acquire an income producing asset, the interest on this borrowing is generally considered to be incurred in the course of producing assessable income.

Taxation Determination TD 93/13 considers the deductibility of interest on a loan used to acquire an income producing property where a non-income producing property (for example, the family home) is used as security for the loan. This determination provides that the deductibility of interest is determined by the use of the borrowed money and not by the security given for the borrowed money.

Taxation Ruling TR 2000/2 discusses the deductibility of interest on repayments and drawings against a line of credit or redraw facility. Although you may not have a line of credit account or redraw facility, the principles in this ruling are relevant in your circumstances.

The original application of the borrowed funds will not determine the deductibility of future funds borrowed. Paragraph 17 of TR 2000/2 states that where money borrowed and applied to a particular use is recouped, the loan can no longer be regarded as continuing to be applied to that use. Where borrowed funds recouped are repaid and reduces the loan balance, those funds have ceased to be outstanding funds used for any purpose.

The deductibility of interest on a further borrowing of money depends upon the use to which the funds are put. Where the new funds are used for private purposes, no deduction is allowed.

A future borrowing of a similar amount previously repaid on an investment loan can not be said to be used for the investment property purchase. Any future loan can not be reclassified into a previous loan. The use of the new funds borrowed determines the deductibility of the associated interest expenses. That is, to return an investment loan to a previous balance requires a new loan. Where the additional borrowings are not used for an income producing purpose, a deduction for the associated interest incurred would not be deductible under section 8-1 of the ITAA 1997.

Where funds from the sale of a main residence has been used to repay an investment loan, the Commissioner can only consider what actually occurred rather than what was intended to occur. The Commissioner has no discretion to ignore a previous transaction on a loan, even where the full consequences of the repayment may not have been understood. The legislation applies to what in fact happened rather than what may have been in mind at some earlier or later point in time.

There is insufficient nexus between future interest expenses and the derivation of assessable rental income when the original investment loan has been paid out. Any future borrowing can not be reclassified or said to re-establish the original loan. That is, the repaid amount can not be re-established and said to be for your investment property. The fact that the bank may call it an investment property loan does not change the deductibility of the interest. As the funds are not being used in relation to your investment property, no deduction is allowed.

You are only entitled to a deduction under section 8-1 of the ITAA 1997 for the interest on a couple of the investment property loans not repaid. No deduction is allowed for interest incurred on the repaid loan or any subsequent loan of a similar amount.

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