Edited version of private ruling

Authorisation Number: 1011854808231

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Ruling

Subject: Rental property interest expenses

Question and answer:

Can you claim an interest deduction based on the market value of your rental property?

No

This ruling applies for the following periods:

Year ending 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

The scheme commenced on:

1 July 2009

Relevant facts and circumstances

In 2010, for personal reasons, you and your spouse decided to move residence.

At the time you had a relatively small amount outstanding on your home loan.

You expected to use the funds obtained from the sale of your old house to help fund the purchase of your new home, with the result that you would still have a relatively low mortgage on the new home

However, due to a dramatic change in the real estate market you were not able to sell your old home for a price you considered reasonable.

Therefore, you decided to rent out your old home.

With the purchase of your new home you now owe a significant amount to the bank, however, you can claim interest on only your old home loan as a tax deduction, which is a very small amount.

Your ineligibility to claim any tax deduction for interest expenses on the new loan has become a huge financial burden on your family.

You would like to claim an interest deduction in your taxation return based on the market value of the old home. You believe that this would reflect a fairer taxation position for you.

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.

The general principles relevant to the deductibility of interest expenses are set out in Taxation Ruling TR 95/25. This ruling provides that interest expense is incurred in gaining or producing assessable income and is not of a capital, private or domestic nature if the interest expense has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. 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.

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 courts have held that where borrowed funds are used for private purposes, such as the acquisition of a private residence, the interest will not be deductible even if there is a secondary result that other income-producing assets are thereby able to be retained (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153).

No portion of the new loan will be deductible under section 8-1 of the ITAA 1997 as these funds were used solely for private purposes to purchase your main residence.

There is no provision in tax law to change or modify a loan in order that it reflects the market value of a rental property.

You can claim a deduction for the interest that relates to the remaining principal of the original loan. This is because the purpose of the original loan was to purchase your old home, which is now producing rental income. As such, there is a nexus between the interest expense and the rental income.