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Ruling

Subject: Interest deduction on redrawn funds

Question:

Are you entitled to a deduction for interest on redrawn funds that were used to finance your new private residence?

Answer:

No

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You have borrowings for two rental properties that you own, as well as mortgage offset accounts, offset against those borrowings.

You had the mortgage offset accounts set up with the assistance of your mortgage broker. The purpose was to have all wages and rent deposited into the offset accounts to offset the interest paid on the mortgages, while not reducing the principal of the loans.

This offset arrangement had been running as planned since 20YY.

You deposited funds directly into the borrowings instead of the offset accounts in error and later withdrew the funds from the borrowings to fund the purchase of your principal place of residence.

The funds which you deposited were received by you from the disposition of a family estate, at a time of extreme stress on you and your family.

Prior to the funds being deposited into the borrowings, you had major personal health, family and business events which placed you under extreme stress over an extended period of time.

These events culminated in you depositing the funds on four occasions into the borrowings, when it was the intention of your fiancé and you to deposit the money briefly while you were looking for another house to purchase.

It was not your intention to pay out the borrowings on the investment properties.

Both accounts were redrawn within two weeks and six weeks of the deposits being made.

It is still your intention to keep the two investment properties.

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.

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. Interest incurred on a loan relating to a rental property will generally be deductible.

Taxation Ruling TR 2000/2 examines the treatment and consequences of payments to loans in excess of the required amount and the subsequent redrawing of these funds.

It is considered that a repayment to a loan account in excess of the required amount is a permanent reduction to this debt. Repayments of an amount to a loan do not create a debt due to the borrower, but simply allows the borrower to then draw funds from the loan to an agreed limit. These redrawn funds therefore constitute new lending and as such, the purpose or use of these drawings is relevant.

Redraws may then result in circumstances where a loan contains mixed purposes. In these instances you are entitled to a deduction for the portion of the interest of the loan which relates to an income producing purpose. Apportionment of the interest between the mixed purposes may be required. Paragraphs 19-20 of TR 2000/2 contain formulas which can be used to calculate the income producing portion of interest.

In Domjan v Commissioner of Taxation 2004 ATC 2204; 56 ATR 1235, the AAT confirmed the view taken by the Commissioner in TR 2000/2. In this case, the taxpayer repaid money into their investment loan account and then used the funds available in the redraw facility to pay for various personal and investment expenses. The question to be answered by the tribunal was whether the whole of the interest incurred on the loan was a deductible expense.

The taxpayer argued that the loan was 'a chose in action with a right to access funds in the redraw facility as if it was a separate sub-account in the loan facility'. The taxpayer further argued they were merely re-accessing private funds when they redrew and that the loan was still only attributable to their investment activities, making the interest deductible. However, the Tribunal rejected this argument.

The Tribunal found that amounts redrawn from this type of loan facility constituted the new borrowing of funds and that consequently, the interest payable on the amounts redrawn for private use was not deductible.

In your situation, making the payments to your rental property borrowings is considered a permanent reduction to the loans. The nature of the redraws you have made are characterised by the use to which they have been put, that is, to fund the purchase of your new private home.

Accordingly the interest relating to these redrawn amounts is of a private nature and is not deductible.