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Edited version of your private ruling
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Ruling
Subject: Interest expenses
Question
Are you entitled to a deduction for interest expenses incurred on money borrowed and used to fund the land and construction costs of an investment property?
Answer:
Yes
Question
Are you entitled to a deduction for interest expenses incurred on money borrowed and used to fund the fees and capitalised interest of an investment property?
Answer:
Yes
Question
Are you entitled to a deduction for interest expenses incurred on money borrowed to create a safety net in case of additional expenses associated with an investment property?
Answer:
No
This ruling applies for the following period
Year ended 30 June 2013
The scheme commenced on
1 July 2012
Relevant facts
You intend on borrowing money to purchase land and construct a residential property for investment purposes.
During the construction period, all interest will be capitalised. No repayments will be made until the property is finished and tenanted. You will be borrowing 100% of the funds required to purchase the land, construct the property, pay fees such as stamp duty and to cover the capitalised interest during the construction.
To ensure there are sufficient funds available to meet any extra costs for potential risks, you intend on borrowing additional funds to act as a safety net. This additional amount will be placed in a mortgage offset account which is linked to the mortgage for your principal place of residence until it is required.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1
Reasons for decision
Section 8-1 of the Income Tax Assessment Act 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.
Where a borrowing is used to acquire an assessable income producing asset, or relates to expenses of an assessable income producing activity, the interest on this borrowing is considered to be incurred in the course of gaining or producing assessable income. The character of a new loan which refinances a previous loan follows from that previous loan: Taxation Ruling TR 95/25
Compound interest, as with ordinary interest, derives its character from the use of the original borrowings: Taxation Determination TD 2008/27.
In your situation, you have funded the interest incurred on your rental loan and the expenses in respect of your rental property from your line of credit and incur interest on that line of credit borrowing. Given the above principles, this interest is accepted as being incurred in producing your assessable income and accordingly you are entitled to a deduction for that interest.
Safety net
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 criterion. The interest will be deductible to the extent that the property is used to produce assessable income.
The safety net funds will be used to offset the interest your principal place of residence. The funds may in future be used towards the costs of the investment property however this is not the purpose to which the money is currently put.
You cannot claim a deduction for interest expenses on money that could potentially be used in gaining or producing assessable income. The interest expense in relation to the safety net is of a private and domestic nature as the money is currently used to reduce the mortgage repayments of your principal place of residence.