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Ruling

Subject: interest on a mixed purpose loan

Question

Are you entitled to a deduction for 100% of the interest incurred on a mixed purpose loan by applying a payment to the non-income producing portion of the loan and reducing it to nil?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You and your spouse purchased a small plot of land.

The original loan was taken out for an amount and in its first year, a repayment was made with the settlement proceeds from two personal investment properties.

A company leases the land from you and your spouse.

The value attributed to the land leased was $X with the balance being attributed to the house.

In the second year, additional funds were used to pay down the loan due to the sale of a third and final investment property.

You and your spouse contend that the extra funds paid into the loan should have been applied to reduce the house portion of the loan to nil.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Reasons for decision

Summary

The payment made to the mixed purpose loan must be applied proportionately to each purpose. You are not entitled to a deduction for 100% of the interest incurred on the loan as the payment has not reduced the non-income producing portion of the loan to nil.

Detailed reasoning

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. 

Taxation Ruling TR 95/25 considers the deductibility of interest. 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. 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 to acquire an income producing asset the interest on the borrowed moneys is considered to be incurred in gaining or producing assessable income.

In addition to examining the deductibility of interest on monies advanced under lines of credit or redraw facilities, Taxation Ruling TR 2000/2 also examines the treatment and consequences of payments to mixed purpose loans, with regards to calculating an amount of deductible interest.

While the ruling distinguishes two purposes of mixed purpose loans being private and income producing, the use or purpose of each portion of the total borrowing is relevant.

Where you make repayments over and above the required minimum payment, you generally cannot choose to notionally allocate the repayments to a particular portion of the total debt, for example the non-income producing portion. Such a repayment is applied proportionately against the outstanding balance of amounts applied to income producing and non-income producing purposes respectively, at the time the repayment is made.

However, TR 2000/2 contains two exceptions to this proportional apportionment of repayments:

· Borrowed monies recouped and repaid: for example, on the sale of a house purchased with borrowed funds, a repayment to a mixed purpose loan with the sale proceeds may be applied to the part of the loan in respect of the house.

· Refinancing mixed purpose debt: it is accepted you may refinance a mixed purpose loan by borrowing an amount under new separate loans, if the new loans are equivalent to each purpose under the original loan.

In this case, the loan has a mixed purpose as it is in respect of leased land and primary residence. The repayment made to this loan cannot be notionally applied to the principal relating to the primary residence.

The payment made to the mixed purpose loan must be applied proportionately to each purpose. The exceptions detailed above do not apply as the payment was not recouped and repaid and the loan has not been refinanced.

Therefore, you are not entitled to a deduction for 100% of the interest incurred on the loan as the payment has not reduced the non-income producing portion of the loan to nil.