Edited version of private ruling

Authorisation Number: 1011777852200

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Ruling

Subject: Rental Property

Question

Is a deduction allowable for the extra interest on your investment property loan that relates to additional funds borrowed to replace your personal savings?

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 are the sole owner of a property and have been living in it as your primary place of residence.

The loan for the property is in both you and your spouse's name.

You want to rent out this property as an investment.

You and your spouse have spent approximately $XX,000 on doing up the property out of your own funds.

You want to increase the level of debt on this property to repay yourselves for the money spent to repair the property.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1
Taxation Administration Act 1953 Section 395-10.

Reasons for decision

Summary

A deduction is allowed for interest expenses if it is incurred in gaining or producing assessable income. However, the interest accrued on funds used to replace your personal savings is considered to be of a private nature; therefore a deduction is not allowed for these expenses.

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, or relate to the earning of exempt income.

Taxation Ruling TR 95/25 deals with the general principles governing deductibility of interest under section 8-1 of the ITAA 1997.

To establish that there is a sufficient connection between incurring an interest expense and the gaining or producing of assessable income, regard must be given to all the circumstances including the use to which the borrowed funds are 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 criteria. Where borrowed funds are used for an income producing asset (for example, a rental property), the interest on the borrowed moneys is considered to be incurred in gaining or producing assessable income. Where a loan contains mixed purposes, for example: partly for income producing purposes and partly for private purposes, only the accrued interest attributable to the funds used for income producing purposes is deductible.

The 'use' test was relied upon by the Board in its decision of Case B11, 70 ATC 46 (Case B11). In that case, the taxpayer purchased a new home with borrowed monies, having decided to retain ownership of his former home with a view to leasing it. The former home was let to a tenant for a term commencing at about the same time that the taxpayer vacated it and took up residence in his new home. The taxpayer's claim for a deduction against the rent received for the interest paid on the borrowed monies was disallowed. It was held that the borrowed monies not only enabled the taxpayer to retain his former home for income-producing purposes but also to acquire ownership of a new house as a family residence. Although it would not have been possible to achieve both these results without borrowing, no apportionment of the interest paid is possible as the deductibility of interest depends directly and only on the use to which the principal is put.

In your case you and your spouse have spent approximately $XX,000, out of your own funds, on doing up the property. To cover your personal expenditure you want to increase the level of debt on the property by $XX,000 to repay yourselves for these expenses and then claim a deduction for the entire interest paid on the loan.

Under the 'use test', the Commissioner does not have any discretion to allow you a deduction for interest accrued on funds used to replace your savings, as this is considered to be of a private nature. Therefore a deduction for the additional interest expenses is not allowed under Section 8-1 of the ITAA 1997.