Edited version of private advice

Authorisation Number: 1051635489241

Date of advice: 13 February 2020

Ruling

Subject: Rental property interest expense deductions.

Question

Are you entitled to continue to claim a deduction for the interest expense on your rental property loan when the rental property was sold at a loss?

Answer

Yes

Question

If so, am I entitled to claim a deduction for interest on the loan after settlement date in the following proportion:

·        X% relating to Property 1

·        X% relating to Property 2

·        X% relating to private use and not deductible

Answer

No

This ruling applies for the following periods:

Year ended XX/XX/XXXX

Year ended XX/XX/XXXX

Year ended XX/XX/XXXX

Year ended XX/XX/XXXX

The scheme commences on:

XX/XX/XXXX

Relevant facts and circumstances

You owned a residential investment property located at location 1 (Property 1) as joint tenant with your spouse.

You and your spouse had an investment property loan (Property 1 Loan) to finance the purchase of Property 1.

The Property 1 was sold at a loss on XX/XX/XXXX and settlement occurred on XX/XX/XXXX.

A carried forward capital loss was declared in your XXXX/XXXX income tax return of $X.

You were the sole owner of a residential investment property located location 2 (Property 2).

Property 2 was sold at a loss on XX/XX/XXXX and settlement occurred on XX/XX/XXXX.

A carried forward capital loss was declared in your XXXX/XXXX income tax return of $X

You were the sole borrower of an investment property loan (Property 2 Loan) used to finance the purchase of Property 2.

Funds from the sale and settlement of Property 2 totalled $X. The funds were used towards reducing the balance owing on the Property 2 Loan in XXXX. There were insufficient funds from the sale of the property to reduce the loan in full.

As at XX/XX/XXXX, prior to the sale and settlement of Property 1, the balance owing on the Property 2 Loan was $X.

Funds from the sale and settlement of Property 1 totalled $X. The funds were dispersed as follows:

·        $X used to partially reduce the balance of the Property 1 Loan

·        $X used to reduce in full the balance of the Property 2 Loan

·        $X used for private purposes

The outstanding loan balance of the Property 1 Loan after the sale and settlement of Property 1 was $X

There is no change to the terms of the Property 1 Loan after the sale and settlement of the property, being principal and interest repayments made over the remaining term of the original X year loan term. The loan maturity date is XX/XX/XXXX.

You and your spouse are not in a financial position to fully repay the Property 1 Loan and therefore are unable to avoid incurring ongoing interest liabilities.

Prior to the sale and settlement of Property 1, you and your spouse claimed as a deduction X% of the Property 1 Loan interest expense. The remaining portion of X% related to private use of the loan funds. No deduction has been claimed for this portion of the interest expense.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

A deduction is allowed for interest taken out on a loan for your rental property. If you use some of the loan money for personal use, you can't claim the interest on that part of the loan. You can claim a deduction for interest expense after a rental property is sold if there continues to be nexus between the interest and the original rental income activities. The allowable rental expense can be claimed in proportion to the legal ownership of the rental property, in your case X% of the allowable interest.

Detailed reasoning

Section 8-1 of the Income Tax Assessment 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.

Expenses incurred relating to a rental property are deductible under section 8-1 of the ITAA 1997 if the property is rented or available for rent in the income year in which you claim the deduction. Interest on the loan used to purchase a property which is rented or available for rent is an allowable deduction under section 8-1 of the ITAA 1997.

You purchased Property 1 jointly with your spouse with borrowed money with the purpose of producing assessable income by renting it. As the property has been rented or available for rent, you are entitled to a deduction for the interest expenses you incur for Property 1 Loan. However, to the extent that the loan is used or refinanced for private purpose, you must apportion the interest expense to account for the private use. As you owned the property jointly with your spouse you are entitled to claim a deduction for X% of the interest costs after apportioning the expense for any private purposes.

The deductibility of interest payments after a rental property is sold is addressed 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 (TR 2004/4). Paragraphs 10 to 14 state:

10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and 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.

11. 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 judgment about the nexus between the outgoing and the income earning activities.

13. However, if the 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 from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred,

the nexus between the outgoings of interest and the relevant income earning activities will be broken.

14. 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.

In your case, the occasion of the outgoing of interest on Property 1 Loan is servicing the loan where the funds were used to purchase Property 1 which produced assessable income. As such there was a clear nexus between the outgoings of interest and your income producing activity.

You and your spouse sold Property 1 at a loss, therefore there were insufficient funds from the sale to reduce the Property 1 Loan in full. This resulted in a residual outstanding loan amount. In addition, your loan financier required a portion of the sale proceeds be allocated towards paying off the Property 2 Loan which still had an outstanding balance after the sale of Property 2.Therefore, the outstanding loan balance on the Property 1 Loan was further increased and you and your spouse still owe a substantial amount to the bank for which you will continue to incur the liability to pay interest.

As the outgoing liability to pay interest will continue to relate solely to Property 1 for which the loan was obtained, you will be entitled to continue to claim a deduction for your share of the interest expense of the outstanding part of the loan. You will need to apportion the interest expense to remove the portion relating to private use as you cannot claim interest on the portion of the loan used for private purposes when the loan was originally taken out or when it was refinanced.

Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners (TR 93/32) deals with rental properties and the division of the net income or the loss between co-owners. Generally, rental income and expense amounts should be declared in the income tax return of the legal owner, that is, the person whose name is on the registered title for the property. If there are joint tenants then each owner should claim 50% each of the rental property expenses. Paragraph 6 states:

6. Accordingly, the income/loss from the 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.

There can be situations where the nature of arrangements, such as beneficial ownership' being different to legal ownership, may create an exception. However, for related taxpayer, such as husband and wife, these situations are treated as not involving such a difference. TR 93/32 goes on to explain at paragraph 41:

41. We consider that there are extremely limited circumstances where the legal and equitable interests are not the same and that there is sufficient evidence to establish that the equitable interest is different from the legal title. We will assume where taxpayers are related, e.g., husband and wife, that the equitable right is exactly the same as the legal title.

In your situation, your ownership interest of Property 1 is X%. Therefore you can only claim X of the allowable interest expense incurred on the Property 1 Loan. You cannot segregate a portion of the allowable loan interest expense and separately claim X% of this portion.