Edited version of your written advice

Authorisation Number: Our reference

Date of advice: 4 October 2017

Ruling

Subject: Rental deductions for loan interest

Question 1

Is $Y of the new borrowings only applicable to purchase your new dwelling?

Answer 1

Yes

Question 2

Is the maximum amount of new borrowings that may relate to the acquisition of your intended rental property $X?

Answer 2

Yes

Question 3

Is any interest of the portion of the $X borrowings that relates to financing interest offset accounts deductible?

Answer 3

No

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

XXXX

Relevant facts and circumstances

You and your spouse jointly purchased a family home in XXXX. Your home mortgage was designed to be repaid over 30 years with fixed repayments.

You subsequently arranged two drawdowns on your mortgage. In both cases these drawdowns were deposited into your mortgage offset account. They were not used to acquire an income producing asset or investment.

In late XXXX you and your spouse jointly purchased another home in a nearby suburb. Your bank arranged two interest-only loans at settlement; one for $X1 and another for $X2. These two loans are cross-collateralised on both properties.

From early XXXX the first purchased property was rented as an investment property which is now managed by a real estate agent.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Tax Administration Act 1953 section 359-35

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for any loss or outgoing that is incurred in gaining or producing your assessable income, to the extent that it is not of a private, capital or domestic nature.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith 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 expenses 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 purposes 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.

Interest on a loan taken out to refinance a loan used to acquire an investment property is deductible to the extent it refinances the balance outstanding that directly relates to the original acquisition of the rental property or it is used to finance other income producing activities.

You have borrowed $X and $Y from your bank. These funds were used to purchase a new residence and to repay an outstanding loan on your previous residence which will be used to generate rental income.

The amount paid to close the initial loan used to purchase your previous dwelling was $X. The remainder of the funds were used to directly settle the purchase the new residence and to repay the deposit paid out your mortgage, so the remaining $Y relates solely to the purchase of the new residence.

In your case, you need to establish what part of the original loan relates to your original property. Only the interest on any outstanding balance that directly relates to the property when it becomes income producing will be deductible. No amount that relates to for example the borrowings to fund the interest offset account relates to the purchase of the previous property.

Here is an example regarding allocation of a loan to a particular purpose.

Kelly and Dean borrow $200,000 to acquire a property as a residence. The initial purpose of the entire $200,000 is to acquire the property. Later they withdraw $100,000 and deposit that withdrawal in an ‘interest offset account. Assuming no other repayment or withdrawal has occurred the funds borrowed that relate to acquiring the property are still only $200,000.

If a repayment of $3,000 is made that needs to be apportioned between the uses of the funds and reduces each accordingly. So the amount relating to acquiring the property is now $198,000 and to the offset account is $99,000.

If interest of $600 was then changed to the account then the amount relating to acquiring the property would be $400 and the amount relating to the offset account would be $200.

Giving a current balance of $297,600 of which $198,400 relates to acquiring the property and $99,200 relating to the financing of the offset account.

Every withdrawal, repayment and charge to the account must be treated in this way and the respective apportionment must be made after each change in the loan balance.

Refinancing the loan does not change the purpose of the loan. As the original amount of the borrowing relating to the rental property was at most $X the amount relating to the rental property cannot exceed that amount unless funds were used to pay for an expense relating directly to the acquisition or up keep of the initial property.

A calculation must now be made taking into account any repayments, including all regular repayments, you have made on the loan for the initial property as these are permanent reductions of the loan which reduce the loan balance. The calculation must also take into account the purpose of any redraws you have made on the loan as any private redraws will affect the deductibility of the interest incurred.

All transactions, both deposits and withdrawn amounts, must be separately identified or characterised so that you can determine which is for income and non-income producing purposes in order to calculate the apportioned interest accurately.

Once the above-mentioned calculation has been performed, it will be possible to calculate that part of the loan balance of the mortgage on the initial property which is therefore directly attributable to the acquisition of the property (or any improvements to the property) after extraneous transactions have been excised.

This calculation must be performed up to and including the date on which the property became income producing (i.e. was rented to tenants on normal commercial terms). From the information you have provided it can be determined that the amount remaining on this loan could not exceed $X. However this does not remove the need to perform this calculation in order to calculate any subsequent deduction claimed.

The allowable proportion of the interest on the $X refinanced on the initial property will be that portion of the $X that relates directly to the acquisition, improvement or upkeep of the property.

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