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Ruling

Subject: Deductibility of interest

Question

If you increase the loan on your rental property to an amount equal to or greater than the increased value of that property in order to finance the construction of a principal place of residence, are you entitled to claim a deduction for the interest incurred on any of the additional amount borrowed?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

You increased the loan on your former principal place of residence in order to finance the construction of a new principal place of residence.

You will rent out the old house.

The value of the old house has risen so that its market value exceeds the amount that was outstanding before you borrowed the additional funds to construct your new principal place of residence.

Reasons for decision

Summary

The deductibility of interest depends on the use of the borrowed money; the security for the loan is not relevant. In your case, you used a portion of the borrowed money to finance the construction of your new home. As you did not use this portion of the borrowed money to purchase an income earning asset, you are not entitled to a deduction for the interest on this part of the loan. The fact that the loan is secured by a rental property is not relevant; it is what the borrowed money is used for that determines the deductibility of interest.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 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 provides that the deductibility of interest is determined by the use for which the borrowed money is intended. 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 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.

Taxation Determination TD 93/13 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.

The application of the above to the question you pose is available in the Australian Taxation Office publication Rental Properties 2011. It states on page 10:

Some rental property owners borrow money to buy a new home and then rent out their previous home. If there is an outstanding loan on the old home and the property is used to produce income, the interest outstanding on the loan, or part of the interest, will be deductible. However, an interest deduction cannot be claimed on the loan used to buy the new home because it is not used to produce income. This is the case whether or not the loan for the new home is secured against the former home.

In your case, the additional amount borrowed was used to construct your new home which you will live in. In applying the use test, the character of the interest on the additional money borrowed will not have sufficient connection with the gaining of your assessable income as the funds were not used to acquire an income producing asset. The additional money borrowed was used for a private purpose.

As the additional money borrowed was not used for income producing purposes, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for any of the interest incurred on the portion of the loan used to construct your new principal place of residence.