Edited version of private ruling

Authorisation Number: 1011853113999

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Ruling

Subject: Interest expense

Question

Are you entitled to a deduction for any of the interest incurred on the interest only loan (Loan 2)?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You are both Australian residents.

You entered into a contract to purchase an investment property, off the plan, in 2007.

Three loans were set up:

Loan 1 is a line of credit to refinance your main residence.

Loan 2 is an interest only loan which you intended to use to cover the deposit and associated costs for the investment property.

Loan 3 is a loan for the balance of the purchase monies which was not drawn down until settlement.

Loan 1 and Loan 2 were drawn down in 2007.

The proceeds from the Loan 2 drawdown were deposited into Loan 1 to offset the cost of interest.

You both pay all of your income into Loan 1 and as such, there was a NIL balance for Loan 1 at 30 June 2009.

The property was not completed until 2008 at which point the deposit and costs of $xxxxx was paid using funds redrawn from Loan 1. This occurred approximately 8 months after funds were drawn down from Loan 2. The deposit and costs of $xxxxx were approximately $30,000 less than the amount of funds that were drawn down from Loan 2.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You deposited the borrowings from Loan 2 into Loan 1 which was the line of credit facility for your principal place of residence and therefore private in nature. Therefore, the draw down from Loan 2 has been used for a private purpose and the interest is not 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.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Accordingly, it follows that if the funds from a loan are used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. 

Where a new loan is used to repay an existing loan, the character of the new loan is derived from the original borrowing. For example, if the original loan was used for private purposes, the funds from the new loan that were applied to repay the original loan will also be considered to have been used for private purposes. Consequently, in those circumstances the interest on the new loan would not be deductible.

Loan 2

In your case, you drew down on the interest only loan (Loan 2) and deposited it into your line of credit facility (Loan 1). As Loan 1 was used to finance your principal place of residence, it is therefore private in nature. Although you intended to use this drawdown from Loan 2 to fund the deposit and associated costs on the purchase of the investment, it was deposited into Loan 1 in order to reduce the interest incurred on this private loan. Therefore, the actual use of the funds from Loan 2 was private in nature. Consequently, no deduction is allowable for any of the interest incurred on Loan 2.

Further information regarding Loan 1

Taxation Ruling TR 2000/2 states that the deductibility of interest on a further borrowing of money under a redraw facility depends upon the use to which the redrawn funds are put. Where the original borrowing is for income producing purposes and the taxpayer uses the redrawn funds wholly or partly for non-income producing purposes, that part of the accrued interest attributable to the redrawn funds used for non-income producing purposes is not deductible. Conversely, where the original borrowing was for private purposes and the redraw was used for income producing purposes, that part of the accrued interest attributable to the redrawn funds used for income producing purposes would be deductible.

You withdrew an amount of $xxxxx from your private line of credit facility to fund the deposit and associated costs for your investment property. TR 2000/2 states that you would be entitled to a deduction for the interest you incur on your private line of credit for the proportion of the loan that is used for income producing purposes (that is, the amount for the deposit and associated costs). However, as your line of credit facility had a nil balance at 30 June 2009, you have repaid all borrowings including the amount used for the deposit and associated costs. For the period from the payment of the deposit and associated costs to the time when the line of credit was reduced to nil, you can claim the portion of the interest incurred on the line of credit that relates to the $xxxxx drawn down as this portion was used for income producing purposes.