Edited version of private ruling

Authorisation Number: 1011645125550

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Ruling

Subject: interest expense

Are you entitled to a partial deduction for the interest you incur on the borrowings originally relating to your investment property?

Yes.

Relevant facts

You bought a rental property with borrowed funds.

You sold the rental property but did not apply the settlement proceeds to the borrowings as the early repayment fees were many thousands of dollars. You applied the settlement amount against other fully deductible investment loans. You used the deposit received on the sale for private purposes.

Reasons for decision

Summary

As a portion of the sale proceeds (the amount of the deposit) was used for private purposes, the interest relating to this amount is not deductible. The remaining interest is deductible.

Detailed reasoning

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.

Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in FC of T 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 criterion. Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income. Further, interest on a new loan used to repay an existing loan, or pay the interest expense incurred on an existing loan of this type will generally also be deductible as the character of the new loan is derived from the original borrowing.

In Placer Pacific Management Pty v. FC of T 95 ATC 4459; (1995) 31 ATR 253 the Full Federal Court said:

In our view AGC should be taken as establishing the proposition that provided the occasion of a business outgoing is to be found in the business operations towards the gaining or producing of assessable income generally, the fact that the outgoing was incurred in a year later than the year in which the income was incurred and the fact in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility.

Taxation Ruling TR 2004/4 contains the Commissioner's views on deductions for interest incurred prior to income activities commencing or after income producing activities have ceased.

Interest expenses incurred after an income producing activity has ceased will be deductible if the occasion of the interest expense is the prior income producing activity.

Deductions for interest in such circumstances will not fail to be deductible merely because:

· the loan is not for a fixed term

· the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty, or

· the original loan is refinanced, whether once or more than once.

The nexus between the outgoings of interest and the income earning activities will be broken if you:

· keep the loan on foot for reasons un-associated with the former income earning activities, or

· make a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred.

Application to your circumstances

You did not wish to pay the large exit fee to extinguish the rental property borrowings and therefore applied the settlement amount to other investment loans. As the settlement amount was used to reduce other loans used for income earning activities, it is considered that the interest on the rental property borrowings (apart from interest on the portion discussed below) continues to have the character of an income related expense.

When the income producing property was sold, the deposit received on the sale was used for private purposes. It is considered that the portion of the interest expense related to this amount no longer has a nexus with your former rental activity. That is, this portion of the interest expense no longer has the character of an income related expense and is not deductible. The remaining interest expense on the borrowings related to your former rental property is deductible.