Edited version of private advice

Authorisation Number: 1051745099220

Date of advice: 1 September 2020

Ruling

Subject: Rental deduction for interest on loans

Question

Can the Trust claim a deduction for the loan interest incurred on the loan with Lender 3?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Some XX years ago, R and S paid off the mortgage on their previous residential property at Property A. Ro and S were joint tenants in common with a 50% share each for Property A.

Then, R and S re-mortgaged Property A to purchase a commercial property (Property B). At the time of purchase, they were registered as joint tenants in common with a 50% share each for Property B. R carried on business from Property B.

Later, R and S transferred Property B to the Trust. R and S are both directors of the trustee.

At about the same time, R and S also placed a mortgage against Property B in the name of the Trust as a line of credit investment loan.

As at the sale time, Property A was being used as security for borrowings which included funds borrowed by the Trust and related to it becoming the owner of Property B.

R and S decided to sell Property A and have the Trust acquire a new residence Property C that they would reside in.

It was intended that the Trust would refinance the loan used to purchase Property B with a replacement loan from Lender 3.

The contract for the purchase of Property C was signed by R and S (on behalf of the Trust) with a long settlement but with an agreement that it would be brought forward to coincide with the settlement of the sale of Property A.

Subsequently, the contract for the sale of Property A was signed by R and S with settlement to occur about two months later. Consequently, the settlement date for Property C was adjusted to also be this date.

The sale of Property A proceeded as expected, but the purchase of Property C was delayed by one week due to a problem with the vendor's bank. R and S were still allowed to move into Property C as scheduled.

R and S paid off the mortgage placed against Property A with part of the sale proceeds from Property A. The balance remaining after payment of other expenses was held in a solicitor's trust account pending completion of the purchase of Property C.

The Trust used the funds from the solicitor's trust account and borrowings from Lender 3 to fund the purchase of Property C.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

The Trust cannot claim a deduction for the loan interest incurred on the loan with Lender 3.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows you 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 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. There must be a sufficient connection between the interest expense and the activities which produce assessable income to claim a deduction. 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.

Accordingly, it follows that if a loan is used for business or investment purposes from which income is to be derived, the interest expense incurred on the loan will be deductible.

The Trust previously claimed interest deductions for the loan used to purchase Property B as it uses Property B for investment purposes and derives rental income from it.

Property A was re-mortgaged to obtain the loan for Property B. However, once Property A was sold, the loan used to purchase Property B had to be paid off. R and S used part of the proceeds from the sale of Property A to pay off this loan. Thus, from the date of settlement for Property A, the loan used to purchase Property B was no longer on foot.

The funds that the Trust has borrowed from Lender 3 were specifically used to finance the purchase of Property C. From this point on, the interest expenses incurred on the loan relate to a private purpose and are therefore not deductible. Therefore, from the date of settlement of Property C, the Trust is unable to claim interest deductions on the Lender 3 loan amount.

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