Edited version of your written advice

Authorisation Number: 1012845942754

Date of Advice: 23 July 2015

Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for interest expenses incurred on loan money used to purchase an investment property after the sale of the property?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2014

The scheme commenced on:

1 July 2013

Relevant facts

You had some investment properties.

You borrowed funds to acquire each one.

Later, on recommendation from the borrowing institution to simplify your borrowings, the loans were consolidated into two loans with properties on each loan used as cross security.

Property A was sold and the proceeds put in a term deposit rather than paying off Loan A. The term deposit was later used to acquire your main residence. The portion of interest expenses from Loan A relating to property A is no longer deductible.

Loan B also has an amount that relates to personal debt.

Later Property B was sold and the sale proceeds were used to reduce the balance on both loan A and loan B. The sale proceeds were enough to reduce the loan associated with Property B to nil.

The borrowing institution applied the funds to reduce the limits on each of the loans to meet their security guidelines.

The result was that loan A was reduced and loan B had an outstanding balance relating to Property B remaining.

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 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith 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.

In your case, your borrowed funds were used to purchase an income producing property. You later sold the property, however the associated loan was not reduced to nil even though there were sufficient funds from the sale to do so. Some of the sale funds were used to repay another mixed purpose loan.

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 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities.

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. Where a taxpayer has the capacity to repay the loan and chooses 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.

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 investment property. You subsequently sold the property, however the funds received were not used to repay the associated loan fully. Some of the funds from the sale of the property were used to repay another loan, which was a mixed purpose loan.

It is acknowledged that it was not directly your decision to reduce loan A, however it remains that the loan relating to Property B was not reduced to nil after the sale of the property even though there were sufficient funds to do so.

As you did not use the money from the sale of your property to fully repay the loan and some of the loan repayments went to a mixed purpose loan, it is not considered that the associated remaining loan is used for income producing purposes after the sale.

Repaying some of the mixed purpose loan A with the funds from the sale has broken the connection of the borrowed funds to your assessable income and therefore no deduction is allowed on the relevant portion of loan B that relates to Property B after selling the property. The fact that you still have other investment properties does not change the above principles.

It is acknowledge that Property B was held as part of the security for loan A, however this does not change the nature of the expense. As highlighted in Taxation Determination TD 93/13 Income tax: is interest paid on a loan used to acquire income producing property an allowable deduction where non income producing property (e.g. the family home) is used as security for the loan? the deductibility of interest is determined by the use of the borrowed money and not by the security given for the borrowed money.

We acknowledge that you may not have fully understood the tax consequences of your loan arrangements, however the Commissioner can only consider what actually occurred.

Your interest expenses on loan B that relate to Property B are no longer sufficiently connected to your prior income earning activity after the sale of the property. Therefore you are not entitled to a deduction for the associated interest expenses incurred after the sale of the property under section 8-1 of the ITAA 1997.