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Ruling

Subject: property loan interest

Question

Can you claim all the interest on a loan against your former primary place of residence as a rental expense when you have swapped mortgages with your previous rental property which is now your primary residence?

Answer: No

This ruling applies for the following periods

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 2010

Relevant facts

Your primary place of residence (A) had a small mortgage owing. You also owned an investment property (B) which had a larger amount owing on it than A.

You moved from A to B, and had A for sale.

Some months later you rented out A, as it had not sold.

Around this time, your bank confirmed a loan security transfer for both properties. As a result the bank has secured the larger mortgage against A, which is rented out, and the lower loan is secured against B, which is your primary place of residence.

Your bank's valuer has valued each property at the same amount.

The loan security transfer has not altered the loan amount previously owing on B when it was a rental property since it became your primary residence.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

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.

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 purpose of the loan on B will be to make available funds for the purpose of purchasing a home which you will live in. Thus, the loan will not be for the purchase of an income producing asset. 

In applying the use test, the character of the interest on the money borrowed under this loan will not have sufficient connection with the operations or activities involved in gaining your assessable income as it will not be used to acquire an income producing asset. The money borrowed will be used for a private purpose.

Accordingly, as this portion of the money borrowed will not be 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 to purchase the home which will be your principal place of residence.