Edited version of your written advice

Authorisation Number: 1051179547131

Date of advice: 11 January 2017

Ruling

Subject: Interest expenses

Question 1

Are you entitled to a deduction for the interest expenses incurred on loan money used for your investment property after the property is sold and before xxx?

Answer

Yes.

Question 2

Are you entitled to a deduction for the interest expenses incurred on loan money used for the construction of your new investment property?

Answer

Yes.

Question 3

Are you entitled to a deduction for the interest expenses incurred on loan money which was not used for the construction of your new investment property?

Answer

No.

Question 4

Are you entitled to a deduction for the interest expenses incurred on the portion of loan money used for the construction of your new investment property?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20YY

Year ended 30 June 20ZZ

Year ended 30 June 20XY

The scheme commenced on:

1 July 20WW

Relevant facts

You owned investment properties which were both financed under one loan.

During the 20VV-WW financial year the properties were sold at a loss.

The loan proceeds were used to partly repay the investment loan and the remaining proceeds were deposited into a linked offset account which was used to fund the construction costs of a subsequent investment property.

For the specified period interest was only charged on the shortfall amount.

On a later date you used your own funds and transferred an amount into the offset account, resulting in no interest being charged.

During the 20WW-XX financial year you used the proceeds in the offset account for the construction of an investment property.

The property was completed and income producing during the 20WW-XX financial year.

Some money was not used for the construction of the investment property.

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.

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, 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 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.

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 private purpose, no deduction is allowed.

In your case you sold your original rental properties at a loss.

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.

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 rental properties. You subsequently sold the properties, however the funds received were insufficient to pay off the associated loan.

Applying the principles of TR 2004/4, it is considered that your interest expenses on your loan are sufficiently connected to your prior investment properties after the sale of the properties and before a given date. Therefore you are entitled to a deduction for the associated interest expenses incurred for this period on the shortfall amount. However, after this date, you had funds and transferred an amount into your offset account. As you had sufficient funds to repay the outstanding amount of the loan, no further interest expense incurred relates sufficiently to your previous rental properties and therefore no further interest is allowed in relation to these now sold properties.

You then used your loan money to build another investment property. Although the arrangement with your bank loan was not processed in the usual manner, after a practical weighing of all the factors of your case, it is accepted that the interest expense is sufficiently connected to your income producing property. Therefore the interest expenses incurred in relation to funds used for the purchase and construction of your investment property are an allowable deduction. However as some of the loan funds have not been used for your investment property, this portion of the loan is not an allowable deduction.