Edited version of your private ruling

Authorisation Number: 1012472133867

Ruling

Subject: Interest expenses

Question 1

Are you entitled to a deduction for the interest expenses incurred on both your joint investment loans for your rental property while you undertake extensions?

Answer

Yes.

Question 2

Are you entitled to a deduction for the interest expenses paid on the shortfall loans held in your spouse's name?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced on

1 July 2012

Relevant facts

You own a rental property that you have been renting for a number of years.

You are doing extensions to the property to increase the value of the property and increase the rental income.

You lodged a development application in 20XX and received approval in early 20YY from the council.

You were assured by the builder that the documentation and building would be no more than three to four months to complete to allow you to re-rent.

The property has not been rented since early 20YY as your tenants at the time vacated the property on establishing your intentions.

You applied for a construction certificate from the council. The construction certificate was granted in the later half of 20YY.

Due to these delays you have lost your builder which you booked 12 months in advance and you are now proceeding as an owner builder. The work is being carried out with family resources.

When the roof of the existing building was removed and the supporting wall opened, it was established that the walls were inadequate to support the extensions. As a result a new approval had to be obtained. This approval was granted in mid 20ZZ.

In early 20AA rain caused additional damage to the opened walls of the existing building. This required additional changes to the internal structure.

Your spouse is doing much of the work on the property and is working four days each week on the extensions. He/She is an employee two days a week.

You hope the extensions will be completed by early 2014.

The property will be re-rented on completion of the extensions.

When purchasing the property you obtained a loan. Your spouse became a guarantor in order for the bank to provide the required funds to purchase the property in your name only. As a result the bank put the loan in joint names.

There are also two other loans in your spouse's name to cover a shortfall.

You have also obtained a separate loan in joint names with your spouse to complete the extensions. You could not refinance your main loan as it has a fixed interest rate and would be costly to refinance.

All payments to the main loan and additional loan including interest are paid by you only.

You have a verbal agreement with your spouse for the shortfall loans in their name where all payments are made by your spouse including interest. You do not have any arrangements in place for you to pay your spouse for the payments and interest expenses incurred for the shortfall loans.

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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

§ it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478, 

§ there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47, and

§ it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 (Munro's case) is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

Taxation Ruling TR 93/32 states that the income/loss from a rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title.

Taxation Ruling TR 2004/4 considers deductions for interest expenses incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) as well as the decisions in the Full Federal Court .

The deductibility of interest is generally determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put.

In Steele's case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. Taxation Ruling TR 2004/4 concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

· the interest is not incurred too soon, is not preliminary to the income earning activities, and is not a prelude to those activities,

· the interest is not private or domestic,

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost,

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

In your case, your property was previously rented, however is not currently rented due to the extension work being carried out. Although rental income from the property may not be derived until early 2014, it is considered that there is sufficient connected to the earning of your assessable income. It is also considered that continuing efforts are being undertaken to earn assessable rental income and the requirements as outlined above are met.

Consequently a deduction is allowable for the interest expense incurred on the joint loans under section 8-1 of the ITAA 1997.

However, the interest paid on the two shortfall loans held in your spouse's name is not an allowable deduction. You are not incurring the expenses on these loans. Therefore, you are not entitled to a deduction for interest expenses on the shortfall loans in your spouse's name.