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Edited version of private ruling
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Ruling
Subject : Interest deduction
Question
Are you entitled to claim a deduction for the interest incurred on a new loan set up to re-establish a repaid investment loan?
Answer
No.
This ruling applies for the following period:
Year ending 30 June 2011
The scheme commences on:
1 July 2010
Relevant facts and circumstances
You decided to sell your main residence (former residence) and purchase a new main residence (new residence).
You borrowed funds for part of the purchase price of the new residence (new residence loan).
You also own a half share in an investment property with your sister. The investment property was purchased using a loan (investment loan). Your former residence was security for your investment loan.
Your financial institution required you to pay out the investment loan in full when your former residence was sold.
This meant that your new residence loan was higher than you had previously intended. This was because some of the funds from the sale of your former residence were used to pay out the investment loan and not used as part payment of the new residence's purchase price.
You intend to borrow funds equivalent to the investment loan balance prior to pay out (new investment loan). These funds will be used to reduce your new residence loan to the amount you originally intended to borrow. The investment property will be used as security for the new investment loan.
You will incur interest expenses on the new investment loan.
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 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.
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 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 criterion. The interest will be deductible to the extent that the funds are used to produce assessable income.
Essentially, it is the use to which the borrowed funds are put rather than the security offered for the loan that will determine the deductibility of the interest. If the borrowed funds are used to produce assessable income, then the interest will be deductible. If the funds are used for non-income producing purposes, then the interest will not be deductible.
In your case, you were required to payout the loan used to purchase your investment property when you sold your former residence. It is your intention to borrow funds equivalent to the investment loan balance prior to pay out, using your rental property as security. The funds borrowed will be used to reduce the debt owing on your new residence's loan to the amount you originally intended to borrow.
As discussed previously, the security used for the loan is not relevant; it is the use of the funds borrowed that is determinative of deductibility. In your situation, the new borrowing will not be used for an income producing purpose as it will be used to reduce the balance of the loan used to purchase your new residence, and as such you will be using the funds borrowed for a private purpose.
It is acknowledged that you did not request the payout of your investment loan, but rather it was the financial institution that insisted that the payment be made. However, the Commissioner does not have any discretion to allow you to reinstate the investment loan to its prior position.
Therefore, any interest accrued with this loan cannot be claimed as a deduction under section 8-1 of the ITAA 1997.