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Edited version of private ruling
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Ruling
Subject: Loan interest deduction
Question 1:
Of the total interest on your new loan secured against your rental property, are you entitled to a deduction for the portion of interest which relates to the total amount previously owing on the original joint loan?
Answer:
No.
Question 2:
Of the total interest on your new loan secured against your rental property, are you entitled to a deduction for the portion of interest which relates to your 50% share of the amount previously owing on the original joint loan?
Answer:
Yes.
Relevant facts
You separated from your spouse.
As a result of the separation, a property settlement occurred between you and your ex-spouse.
The property settlement consent orders included the following directives:
· You were to transfer your interest in the property which was the family home, to your ex-spouse.
· You were to refinance the loan secured over the former family home so that the property became unencumbered.
· Your ex-spouse was to transfer to you her interest in the rental property.
· You were to refinance into your name only, the loan secured over the rental property.
· Your ex-spouse was to transfer to you any shares or interest she had in two companies.
· An amount of funds was to be allocated to your ex-spouse out of your interest in a certain superannuation fund.
· Your ex-spouse was to receive certain other amounts relating to a superannuation fund.
· Your ex-spouse was to transfer to you any interest or units that she had in a certain unit trust.
The rental property had been owned jointly by you and your ex-spouse. There was an amount owing on the property.
In accordance with the property settlement consent orders, you took out a new loan in your name only for a larger amount than the original amount owing, secured against the rental property. You were able to borrow a higher amount as the value of the property had increased. You used part of the funds borrowed to pay out the existing joint loan on the rental property.
Contentions
You believe that of the interest on the new loan, the portion that relates to the total original amount outstanding on the joint loan on the rental property should be deductible.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1.
Reasons for decision
Section 8-1 of the Income Tax Assessment Act 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.
The general principles relevant to the deductibility of interest expense are set out in Taxation Ruling TR 95/25. The test is one of characterisation and the essential character of an expense is a question of fact to be determined by reference to all the circumstances.
Where a loan is taken out, the use test is applied to determine the deductibility of the interest. This is the basic test of deductibility of interest and looks to the application of the borrowed funds as the main criteria. This 'use' test was established in FC of T v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339.
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.
You borrowed funds to effect a property settlement order after your separation from your ex-spouse. As part of the settlement, your ex-spouse gained full title of a property and payments from a superannuation fund and you gained full title of a rental property, shares in two companies and units in a unit trust.
The loan you have taken out is only one of your obligations under the agreement and your ex-spouse's share of the rental property is only one of the assets you have acquired under the agreement. Therefore, your loan cannot be regarded as funding the purchase of your ex-spouse's share of the rental property. Rather it is simply one of the obligations you have under a property settlement, in return for which you will receive a number of assets.
A taxpayer's marital arrangements are regarded as being private in nature. Consequently, the interest on your loan would generally not be deductible as it would be an expense relating to your property settlement rather than an expense incurred in earning assessable income.
However, as you were already a joint owner of the rental property, we accept that of the total amount borrowed, half of the original outstanding amount refinanced your share of the original loan on the rental property. Therefore, you are still entitled to a deduction for the interest on this portion of the new loan. However, we do not accept that the remainder of the amount borrowed, 'purchased' your ex-spouse's share of the rental property; rather it was borrowed in order to meet your obligations under the property settlement. This is a private use and therefore the interest on these funds is not deductible.