Edited version of private ruling

Authorisation Number: 1011855945191

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Ruling

Subject: Rental Property Deductions

Question

Are you entitled to a deduction for the interest expenses of your loan, which is secured against your rental property, if the funds were used to purchase your primary place of residence?

Answer

No.

This ruling applies for the following periods:

· Year ended 30 June 2011

· Year ending 30 June 2012

· Year ending 30 June 2013

· Year ending 30 June 2014

· Year ending 30 June 2015

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You purchased your first property in 20XX.

You paid off the original mortgage on this property in 20XX.

In 20XX you remortgaged the property to XX% of its market value, with the intention of it becoming a rental property.

You used the borrowed funds to purchase a second property.

In 20XX you moved out of your first property and into the second property.

A tenant began to rent the first property from you in 20XX.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

As the borrowed funds have been used for a private purpose and not for income producing purposes, you are not entitled to a deduction for the interest expenses on your loan that is secured against your rental property.

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 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. However, where borrowed funds are used for private purposes, such as the acquisition of a home, the interest will not be deductible even if there is a secondary result that other assets are able to be retained for the purpose of producing assessable income.

The 'use' test was relied upon by the Board in its decision of Case B11, 70 ATC 46. 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 remortgaged the first property, which you owned outright, with the intention of turning it into a rental property. You then used the borrowed funds to purchase a second property, as your new primary place of residence.

The security used for the loan is not relevant; it is the use of the funds borrowed that is determinative of deductibility.

Accordingly, as the borrowed funds have been used for a private purpose and not for income producing purposes, you are not entitled to a deduction for the interest expenses on your loan that is secured against your rental property.