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Ruling
Subject: Property loan refinance
Question
If you refinance the loan on your rental property to finance a divorce settlement will the interest on that part of the loan be deductible?
Answer
No.
This ruling applies for the following period
Year ended 30 June 2013
The scheme commenced on
1 July 2012
Relevant facts and circumstances
You are the sole owner of a property which has been rented or available for rent for over three years.
The loan for the property is solely in your name.
Recently you and your former spouse separated and you are currently negotiating property settlement terms.
The rental property is currently valued at considerably more than the loan amount owing on it.
You believe that when the property settlement terms are finalised, your former spouse will receive at least half the current value of the property.
To pay out this amount you wish to borrow by refinancing the loan on the investment property. This will enable you to pay out the settlement to your former spouse without having to sell the investment property.
It is your intention to continue to rent out the property to tenants following settlement with your former spouse.
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.
In your case, the purpose of a portion of the new loan will be to make available funds to pay your former spouse an amount owed for your divorce settlement.
As you are the sole title holder on the title deed for the property, your former spouse has no legal share of the property.
It is acknowledged that the amount of additional funds borrowed will be based on the current value of your rental property, however you are the sole owner of the property and the additional amount borrowed will not be used for the purchase of an income producing asset.
In applying the use test, the character of the interest on the money borrowed under this part of the new 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 which will be used to settle the amount owing to your former spouse.