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Ruling

Subject: Deduction-interest

Question 1:

Are you entitled to a deduction for interest expenses after your rental property has been sold?

Answer: Yes.

Question 2:

Is a deduction allowed for the portion of the interest on your consolidated loan that is attributable to your investment loan?

Answer: Yes.

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 commenced on:

1 July 2010

Relevant facts

You and your spouse purchased your main residence with a home loan from a financial institution.

You purchased an investment property with funds borrowed from another financial institution.

The property was rented until it was sold.

You claimed interest expenses up until the investment property was sold.

All the proceeds from the sale of the investment property were used to reduce the original investment loan balance.

You and your spouse did not have the capacity to repay the outstanding balance of the investment loan.

Your investment property loan was consolidated with your home loan.

You intend to make repayments on your consolidated loan in future financial years from your salary and wages.

You and your spouse have not refinanced or drawn down additional funds from the consolidated loan.

Relevant legislative provisions

Income Tax Assessment Act 1997 - section 8-1.

Reasons for decision

Interest deduction
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.

Taxation Ruling TR 95/25 provides that the deductibility of interest is determined by the use of the borrowed money. The use test looks to the application of the borrowed funds as the main criteria (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153).

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. Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income.

However, there may be instances where the loan has a mixed purpose. Where there is a mixed purpose, only the interest on the portion of the borrowing which is attributed to an income producing purpose is deductible. An apportionment must be made on a fair and reasonable basis.

Further, interest on a new loan used to repay an existing loan that is used for income producing purposes will generally also be deductible as the character of the new loan is derived from the original borrowing (Taxation Ruling TR 95/25). That is, when a loan is refinanced, the new loan takes on the same character as the previous loan.

In your case, you purchased an investment property with a loan from a financial institution. The property was used for income producing purposes. Accordingly you are entitled to a deduction for the interest expense up until the property was sold.

Deductibility of interest with the cessation of income producing activity
Taxation Ruling TR 2004/4 provides the Commissioner's view on the deductibility of interest where the income-producing asset has been disposed of and the taxpayer is still liable for the balance of the loan.

In general, the interest expense will continue to be deductible where:

· the taxpayer borrowed money to acquire an income-producing asset

· the income-producing asset has been disposed of

· the proceeds from the disposal have been applied against the loan and not used for personal or non-income producing purposes

· the taxpayer does not have the legal power to repay the loan (FC of T v. Brown 99 ATC 4600, (1999) 43 ATR 1) or does not have the financial resources to repay the loan fully (FC of T v. Jones 2002 ATC 4135, (2002) 49 ATR 188), and

· is unable to avoid incurring ongoing interest liabilities.

In this situation, a nexus will continue to exist between the interest outgoings and the relevant income earning activities at least until the end of the period during which the interest cannot be avoided.

However, where it can be inferred that a taxpayer has:

· kept the loan on foot for reasons unassociated with the former income earning activities, or

· made a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred

· the nexus between the outgoings and relevant income-earning activities will be broken.

In your case, your obligation to pay the interest expenses arose from your former investment property. You do not currently have the financial resources to pay out the existing debt. The connection with the income earning activities has not been broken because the investment property was sold.

The outstanding debt was consolidated with your home loan and is now considered a mixed purpose loan. The interest expenses on the consolidated loan which relates to the previous investment loan takes on the same character as the previous loan.

Therefore you are entitled to a deduction under section 8-1 of the ITAA 1997 for the interest on the investment loan up until it was consolidated with the home loan in July 2011. In addition, you are entitled to a deduction under section 8-1 of the ITAA 1997 for the portion of the interest on the consolidated loan which relates to the paying out of the previous investment loan.