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Ruling
Subject: Rental property expenses - interest
Question 1:
Is the interest on funds borrowed for a private purpose deductible where an income producing property is used as security for the loan?
Answer:
No
This ruling applies for the following periods:
Year ending 30 June 2010
Year ending 30 June 2011
Year ending 30 June 2012
Year ending 30 June 2013
Year ending 30 June 2014
Year ending 30 June 2015
Year ending 30 June 2016
The scheme commences on:
1 July 2009
Relevant facts and circumstances
You purchased a rental property in conjunction with your spouse and other family members in 200X. The property was purchased with cash and no borrowings were required.
You and your spouse subsequently sold your existing main residence and purchased a new main residence which required additional borrowings.
Due to the additional interest payable on your main residence and the tax payable on the rental income, you are considering selling the rental property. Your other family members do not wish to sell the rental property.
You propose to borrow funds against the rental property in order to reduce the mortgage and therefore the interest expenses on your main residence.
Relevant legislative provisions
Income Tax Assessment Act 1997
Reasons for decision
The deductibility of a loss or outgoing comprising interest under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) depends upon satisfying the words of the section, that is, being able to show that the loss or outgoing (or the part of the loss or outgoing in an appropriate case of apportionment) is:
(a) incurred by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature; or
(b) necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature.
Whether or not a loss or outgoing incurred by a taxpayer satisfies the requirements of section 8-1 is dependent on all the facts and matters relating to the loss or outgoing incurred by the taxpayer in question. However, the general principles relevant to the question of whether interest is deductible under section 8-1 include:
The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.
The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower.
A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity.
Interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets.
The interest will not be deductible, to the extent to which it is private or domestic in nature, or is incurred in relation to the gaining or production of exempt income.
The property used as security for the loan is not relevant, only the purpose to which the funds are to be put in determining whether the interest is deductible.
In your case, your rental property was purchased with cash and is fully owned. You wish to borrow against your rental property in order to reduce the interest payments on your principal residence and then claim as a tax deduction the interest incurred.
The use of the borrowed funds is therefore for a private purpose, that is, to reduce the interest payable on your principal residence. As the borrowed funds are to be used for a private purpose, you cannot deduct the interest expenses.
Interest payable on any loan taken against your rental property would only be deductible if the borrowed funds were used for another income producing purpose, such as renovating your existing rental property, or purchasing an additional rental property or another income producing investment such as shares. Essentially it is impossible to purchase a property twice - as your rental property is already fully owned you cannot claim any further interest relating to the initial purchase of the property.
Even though the borrowed funds will use your rental property as security, it is the use to which the borrowed funds are put which determines whether they are deductible.