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Authorisation Number: 1011957649194

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Ruling

Subject: Rental property - interest - incurred after sale - new rental property purchased with sale proceeds

Question 1

Will all of the interest on your loan be deductible if you sell your existing rental property and use all the sale proceeds to purchase another rental property?

Answer

Yes.

Question 2

Will all of the interest on your loan be deductible if you sell your existing rental property and invest the sale proceeds in a term deposit until you locate a suitable rental property to purchase?

Answer

No.

Question 3

Will some of the interest on your loan be deductible if you sell your existing rental property and invest the sale proceeds in a term deposit until you locate a suitable rental property to purchase?

Answer

Yes.

This ruling applies for the following period

1 July 2011 to 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

You obtained a loan to purchase a rental property.

You intend on selling the property.

Due to the current market you expect to make a loss on the sale of the property.

You are selling the property due to the large losses it is making each year.

You do not intend on paying out the loan.

You intend on buying another rental property with the sale proceeds.

You will purchase a property that will give you a higher rate of return then the property you are selling.

You will invest the sale proceeds in a term deposit until you locate a suitable property to purchase.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

You will be entitled to a deduction for all of the interest on your loan if you sell your existing rental property and use all the sale proceeds to purchase another rental property. This remains the case even if the loan amount is more than the purchase price of the new rental property.

However, during the period the borrowed funds are invested in a term deposit your interest deductions will be limited to the amount of interest income earned from the term deposit.

Detailed reasoning

You can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income except where the loss or outgoing is capital, private or domestic in nature or relates to the earning of exempt income (section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)).

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

The character of interest on a loan is generally ascertained by reference to the purpose of the loan (Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613) and the use to which the loan money is put (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153).

In cases where the income from the investment is less than the interest incurred on the funds borrowed to make the investment, it may be necessary to have regard to the taxpayer's subjective purpose, motive or intention in incurring those expenses and examine the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible.

In such cases a commonsense or practical weighing up of all the circumstances needs to be undertaken, including the direct and indirect objectives and advantages, to determine whether, objectively, the funds are used in the production of assessable income. If, after weighing all the circumstances, it can be concluded that the borrowed funds are genuinely, and not colourably, used in an assessable income producing activity, a deduction will be allowed for the interest on those funds. However, if it is concluded that the borrowed funds are being used in the independent pursuit of some other objective then the interest must be apportioned between the pursuit of assessable income and the other objective.

In your case, when you sell your existing rental property and invest the sale proceeds in a term deposit, the interest on the loan will be incurred for both an income producing and a non-income producing purpose. While your main purpose for not paying out the loan and incurring interest expenses is to ensure that you have funds readily available to purchase another rental property (a non-income producing purpose), the borrowed money will be invested in a term deposit and will derive interest (an income producing purpose).

Having funds available to purchase a rental property in the future is not considered to be an income producing purpose as the nexus between the interest expense and any rental income to be earned from a property that will be purchased at some time in the future is too remote. The interest is incurred at a point too soon to be considered to be incurred in the earning of rental income.

As you are considered to incur the interest expense for dual purposes during the intervening period where the loan funds have not been used to acquire a rental property and are invested in a term deposit, your deduction for the interest expense is limited to the income earned from the term deposit.

When you withdraw the funds from the term deposit and use all of them to purchase a rental property, the interest on the loan will be fully deductible.