Edited version of your written advice

Authorisation Number: 1012772398626

Ruling

Subject: interest expenses

Question 1

Are you able to claim a deduction for the interest expenses incurred on an outstanding loan used for your investment property after the property is sold?

Answer

Yes.

Question 2

Are you able to claim a deduction for the interest expenses incurred on a loan that has been refinanced on another investment property to pay off the outstanding balance of the sold investment property?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commenced on:

1 July 2014

Relevant facts

You own two investment properties and each investment property has a separate loan.

You are in the process of selling one of these properties (property 1) in an arm's length transaction.

The money received from the sale will be used to reduce the loan specific to that property. However the sale money will be insufficient to pay out the full amount of that loan.

You are considering two options of servicing this outstanding loan amount:

Keep two separate loans, continuing to pay them both off separately

Or

Refinance the loan on the kept property (property 2) in order to pay off the outstanding loan amount on property 1 in full, thus increasing the loan on property 2 by the amount remaining on the loan from property 1.

Both properties are solely owned by you.

You have no other means of paying off the outstanding loan amount remaining after applying the sale proceeds of property 1.

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.

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 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.

The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4. Paragraph 10 of TR 2004/4 states that where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and the relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

However: as highlighted in paragraphs 13 and 14 of TR 2004/4, if a taxpayer keeps the loan on foot for reasons unassociated with the former income earning activities or makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived that is not related to the original income earning debt, then the nexus between the outgoings of interest and the relevant income earning activities will be broken. A legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgement about the nexus between the outgoing and the income earning activities.

In your case, your borrowed funds were used to purchase an income producing rental property. You subsequently sold the property, however the funds received were insufficient to pay off the associated loan. You still have an outstanding amount in relation to this property.

As your borrowed funds were used to produce assessable income, it is considered that the funds were used for income producing purposes. It is not considered that the loan is being kept for other non-income earning reasons. As the investment is regarded as being an income earning activity, the principles of TR 2004/4 apply.

It is considered that your interest expenses on your loan are sufficiently connected to your prior income earning activity after the sale of the property. Therefore you are entitled to a deduction for the associated interest expenses incurred.

It follows that whether you keep both loans separate, or refinance property 2 to pay out the remaining loan from property 1, in your case, there remains a sufficient nexus between the outgoings of interest and the relevant income earning activities.

Additional information

It should be noted that if you do at any stage have the capacity to repay the loan and choose not to, the Commissioner would generally consider that the nexus between the interest and the gaining of assessable income would be broken and further interest deductions would not be allowable.