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Ruling

Subject: interest expenses

Question 1

Are you entitled to a deduction for 40% of the interest expenses on the total of your original loan?

Answer

No.

Question 2

Are you entitled to a deduction for half of 40% of the interest expenses incurred on the portion of your original loan that relates to the land value from the date your second dwelling is available for rent?

Answer

Yes.

Question 3

Are you entitled to a deduction for interest expenses on your original loan that relates to the value of your main residence?

Answer

No.

Question 4

Are you entitled to a deduction for your share of the interest expenses on the additional funds borrowed and used to build a rental property?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts

You purchased a property in which you currently live.

The property is held in joint names with you owning a 50% share.

You intend to build a second dwelling on the property. This dwelling will be detached from your main residence and will be used as a rental property.

You will not subdivide the property.

Sixty percent of the land will be used for private purposes and the second dwelling will be built on forty percent of the land.

The second dwelling will be rented at a commercial rate.

No part of your main residence will be rented out.

You borrowed money to purchase the property. You currently have a loan in relation to the property.

The loan is in joint names.

To build the second dwelling you will need to borrow further funds.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Interest expenses 

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 the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. However, where a loan relates to a person's main residence or other private purpose, no deduction is allowed.

Apportionment

Co-owners of a rental property divide the income and expenses for the rental property in line with their legal interest in the property (Taxation Ruling TR 93/32).

In your case you intend to borrow a further amount to build a rental property. This borrowing is solely for income producing purposes. Therefore the interest expenses are deductible under section 8-1 of the ITAA 1997. As you own a 50% share of the property, you are entitled to a deduction equal to 50% of the associated interest expenses incurred on these additional funds.

However, your original loan was borrowed for private purposes, that is, for your main residence. You now wish to use some of your land to build a rental property. As some of the land will be used for income producing purposes, a portion of this original loan will be deductible.

Where an expense comprises deductible and non-deductible components, then apportionment of the expense is required. Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances.

As your original loan relates to purchasing your main residence, it is considered that this loan still mainly relates to a private purpose. No part of your existing main residence will be rented out or used for income producing purposes. Therefore it follows that no part of the portion of the loan that relates to your main residence building is deductible. However, it is acknowledged that 40% of your land will be used for income producing purposes in the future. Therefore in your circumstances it is considered that a deduction for the interest expenses that relate to the value of your land is an allowable deduction. As such a fair and reasonable apportionment may be obtained by contacting a valuer to determine the dollar value that relates to your home and the dollar value that relates to your land. Such a valuation should be kept to support your allowable deduction. You will be entitled to a 50% share of 40% of the interest expense incurred that relates to your land value portion. For example, where you purchased the property for $400,000 and the valuer advises that $300,000 relates to your residence and $100,000 relates to the land, then the deductible amount is 40% of one quarter of the interest expenses on the outstanding amount on the loan, of which you are entitled to 50% of this amount according to your ownership in the land.

When deduction is allowable

Taxation Ruling TR 2004/4 considers deductions for interest incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case).

In Steele's case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. It follows from Steele's case that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing assessable income in the following circumstances:

· the interest is not incurred 'too soon', is not preliminary to the income earning activities and is not a prelude to those activities,

· the interest is not private or domestic,

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between the outgoings and assessable income is lost,

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

In your case, your original borrowings were not for income producing purposes and the use of the funds are for private purposes. The principles in TR 2004/4 do not apply. Therefore you are only allowed a deduction for your share of 40% of the relevant portion of the borrowings that relates to the land from the day the property is rented or available for rent.

However, on the additional borrowing, you will incur the associated interest on these borrowed funds to build a property that is solely intended to be used for income producing purposes. Where the property is completed and rented in a reasonable time, the interest expense is considered to be deductible from the day you take out the additional borrowings and incur the relevant interest expenses. Therefore, you are entitled to a deduction for 50% of the interest incurred on these funds used to build your rental property under section 8-1 of the ITAA 1997.