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Edited version of private ruling
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Ruling
Subject: Loan interest deductions
Question
Are you entitled to a deduction for the interest on a rental property loan which has been reduced to a nil balance and then re-drawn for a non-income producing purpose?
Answer: No
This ruling applies for the following periods
Year ending 30 June 2011
Year ending 30 June 2012
Year ending 30 June 2013
Year ending 30 June 2014
The scheme commenced on
1 July 2010
Relevant facts
You purchased your primary place of residence in 200X with a combination of two loans (loan A and loan B).
When you moved from the home some time later, it was rented to tenants.
In late 200Y you deposited a lump sum in loan A, reducing the balance to zero.
Loan B's balance was unaffected by the deposit against loan A.
Early in the recent year you used the redraw facility to draw an amount on loan A which created a loan liability on loan A. The redrawn amount was used for non-deductible purposes.
Late in the recent year you purchased a new primary place of residence. At this time you refinanced and consolidated loans A and B into loan C.
Reasons for decision
Interest is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature or incurred in gaining or producing exempt income.
Taxation Ruling TR 95/25 considers the deductibility of interest. 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 property is used to produce assessable income.
It is considered that a repayment to a loan account is a permanent reduction to this debt. Repayments of an amount to a loan do not create a debt due to the borrower. It simply allows the borrower the right to then draw funds to an agreed limit. These redrawn funds therefore constitute new lending and as such, the purpose or use of these drawings is relevant.
In your case, the redrawn funds were not used for an income producing purpose.
Therefore, at the time that you placed the funds into loan A reducing the balance of this loan to zero for any subsequent redraw to have the interest deductible, the redrawn funds would have to be used for an income producing purpose.
In your case the full amount of loan C would not be deductible. The interest on loan C would need to be apportioned between the relevant loan A and loan B amounts which were consolidated into loan C.