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Ruling

Subject: Rental deductions

Question and answer

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for interest expenses on a new loan taken out to purchase your home, where the loan is secured by an investment property you own?

No

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

You moved to Australia from overseas.

You were unable to find suitable rental accommodation but found a unit that was for sale and would suffice as temporary accommodation until you found a suitable permanent home.

It was also your intention to keep this property as an investment property when you eventually found a permanent home.

You purchased the unit in your name for cash as this was the most cost effective and financially viable way for you at the time.

You lived in the unit while you looked for a permanent home.

You found a suitable house to purchase. You borrowed money from the bank under a line of credit using the investment property as security to enable you to purchase the house in cash. The loan is secured 100% by the investment property and the bank lent you 80% of the value of the investment property.

Your investment property is now being rented out through a real estate agent.

You believe that the new loan taken out was for the purpose of retaining your unit as an investment property and not for the purpose of purchasing a new home to live in.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

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 95/25 (TR 95/25) Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. TR 95/25 specifies that to determine whether interest expenses are deductible under section 8-1 of the ITAA 1997, it is necessary to look at the use to which the borrowings are put.

The 'use' test established in the Federal Court case FC of T v Munro 91926) 38 CLR 153, 97 ATC 5041 is the basic test for the deductibility of interest and looks at the application of the borrowed funds as the main criterion. 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. Paragraph 29 of TR 95/25 states:

In FC of T v. Munro (1926) 38 CLR 153 ( Munro ) the High Court considered whether interest incurred on a borrowing which was not used to produce assessable income, but was secured by an income producing asset, was deductible. The taxpayer argued that if the interest obligations were not discharged, the income producing asset that secured the borrowing would be in jeopardy. Thus, the discharge of the obligation to pay interest was incurred in producing assessable income. The High Court rejected this proposition.

TD 93/13 Income tax: is interest paid on a loan used to acquire income producing property an allowable deduction where non income producing property (eg the family home) is used as security for the loan? also considers the relevance of security provided for a loan and establishes the principle that deductibility is determined by the use of the borrowed money and the choice of assets used as security for a loan is irrelevant. TD 93/13 examines the situation where a non income producing asset is used as security for a loan to purchase an income producing asset. The interest is deductible because of the use to which the borrowed money is applied. Equally, where an income producing asset is used as security for a loan to purchase a non income producing asset the interest will not be deductible.

You own the property which was used as your main residence that will now be an investment property (property A). You obtained a loan to purchase another property to subsequently be used as your new main residence (property B). The new loan is secured by the investment property but was for the purpose to enable you to purchase a new home that was not for investment purposes.

While we accept that property A will be used for investment purposes to derive rental income, the debt or liability does not exist for that property as you purchased it for cash. Obtaining the new loan to acquire property B even though it is secured by your investment property, is effectively a new transaction and has no bearing to property A. It cannot be said that the borrowings to purchase property B is for income producing purposes as you intend to live in the property as your main residence.

In applying the use test, the character of the interest on the money borrowed under the new loan does not have sufficient connection with the operation or activities involved in gaining assessable income as it was not used to acquire an income producing asset. The money borrowed was used for a private purpose.

Therefore, you are not entitled to claim a deduction for the interest expenses incurred on a loan to acquire a property for you to live in as your main residence. The interest expenses are considered private and domestic in nature and are not deductible under section 8-1 of the ITAA 1997.