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Ruling

Subject: Loan interest deduction

Question

Are you entitled to a deduction for all the interest you incur on your loan?

Answer: 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 have a property that is owner occupied (property A) and an investment property (property B) which is currently rented.

Property A has been sold, with a settlement date in 2011.

Property B has a current loan balance. Your bank requires you to reduce the investment loan to 86% of the original property valuation.

Once the sale of property A is finalised, you will be refinancing the investment loan to 90% of the new increased property valuation.

You will be putting the additional borrowings toward the purchase of your new principal place of residence.

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 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.

In your case, the purpose and use of the additional amount of the new loan will be to fund the purchase of your new private residence, which is private in nature and not related to an income producing purpose, notwithstanding your bank's requirement to initially reduce the borrowing.

Accordingly, as the character of this portion of the new borrowing is private and will not be used for income producing purposes, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for the interest incurred on this portion of the loan.