Edited version of your private ruling

Authorisation Number: 1012607676164

Ruling

Subject: Rental property expenses

Question 1

Are you entitled to claim a deduction for 100% of the interest incurred on the loan for property B?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You lived in property A as your principal place of residence.

In 200X, you purchased an investment property (property B) with a loan amount of $XXXX.

In 200Y you sold property A. Property B became your principal place of residence.

The bank required you at this time to reduce the loan amount to $XXXX to ensure they held 20% equity in the property.

You are looking to purchase property C to become your new principal place of residence. Property B will become an investment property.

You will refinance Property B to increase the loan amount back to $XXXX.

The 20% would be moved to property C but continue to act as security to hold property B.

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.

Taxation Ruling TR 95/25 (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, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test established in the Federal Court case FC of T v Munro 91926) 38 CLR 153, 97 ATC 5041 is the basic test for the deductibility of interest and looks at the application of the borrowed funds as the main criterion. 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.

Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. However, where a loan relates to a person's main residence or other private purpose, no deduction is allowed.

The choice of assets used as security for a loan is irrelevant in determining the deductibility of interest incurred on that loan. 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: that is, to acquire an income producing asset. Equally, where an income producing asset is used as security for a loan used to acquire a non-income producing asset, the interest will not be deductible as the use of the loan funds is private in nature: Taxation Ruling TR 93/13.

Application to your circumstances

In your case, you purchased property B in 200X and financed the purchase with a loan for $XXXX. You moved into the property in 200Y and it became your main residence. Your bank required that you make a payment to reduce the loan amount by 20%.

You now plan on buying a new property for your main residence and will rent out property B. In order to increase the loan amount for property B to $XXXX you will refinance or reloan. The increase in the loan for property B will be used to fund the purchase of your new principal place of residence. Therefore, the use of the borrowed funds is to purchase your new main residence which is private in nature.

While it is accepted that repaying the part of the loan was a requirement of the bank, this does not change the fact that part of the loan was repaid. Any new borrowings of the repaid amount are not for the rental property. Therefore, you will not be entitled to a deduction for 100% of the interest incurred on the loan for property B.