Edited version of private advice

Authorisation Number: 1051942547312

Date of advice: 27 January 2022

Ruling

Subject: Rental deductions - interest expense

Question

Are you entitled to claim a deduction for the interest expense incurred on the redrawn amount portion of your investment loan?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 2020

Relevant facts and circumstances

You entered into a contract to purchase your property with a developer.

The contract price of the property was $XX. You paid an initial XX% deposit of $XX and signed the contract in XX.

You both own a 50% equal share in the property as tenants in common.

You approached the bank for an investment loan. You took out a loan with a fixed rate of XX% for a term of XX years.

Prior to settlement, the bank undertook a valuation of your property and valued the property lower than the original contract price.

You advised the bank only allowed you to borrow up to XX% of the valuation for the property. The bank valued your property at $XX.

You advised the reason for the valuation shortfall was due to the prevalent market conditions of properties in Victoria at the time of purchase.

The developer dropped the contract price by $XX as a result of the valuation, however you were advised by the developer you were still required to pay stamp duty of the original contract amount.

The bank advised you were required to contribute $XX (the shortfall amount) from your own savings toward the purchase of your property.

You decided to proceed with the purchase of the property as you did not want to lose your deposit. Settlement occurred in XX.

The total loan amount as of XX was $XX. You provided the shortfall amount to the bank and the bank forwarded the funds to the developer at settlement.

Since your ownership, you advised market conditions have improved significantly in your state and you have approached the bank to enquire about re-drawing funds from your investment loan.

You intend to re-draw the shortfall amount you initially contributed at settlement from your investment loan.

You advised the bank has agreed to this arrangement in principle, however it is subject to another valuation of the property and the re-draw will only be approved if the total loan amount does not exceed XX% of the current valuation.

You intend to use the redrawn funds to assist your family member to purchase their first home. You will act as guarantor for their home loan.

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 deals with the general principles governing deductibility of interest under section 8-1 of the ITAA 1997.

To establish a sufficient connection between incurring an interest expense and the gaining or producing of assessable income, 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 FC of T v Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks to the application of the borrowed funds as the main criteria.

Taxation Ruling TR 2000/2: Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities (TR 2000/2) provides the ATO view on the deductibility of interest on money drawn down on a loan with redraw facilities. In this ruling the Commissioner considers a redraw from a loan account, is a separate borrowing. Therefore, the deductibility of the interest on that separate borrowing depends on whether the interest is incurred in gaining or producing assessable income regardless of the original purpose of the funds.

To the extent borrowings are used for income producing purposes, that part of the accrued interest attributable to those borrowings is deductible. Where the original borrowing is for income producing purposes and the taxpayer uses the redrawn funds wholly or partly for non-income producing purposes, that part of the accrued interest attributable to the redrawn funds used for non-income producing purposes is not deductible.

If you subsequently redraw these amounts, you can only deduct the additional interest if the funds are put to a new income producing purpose.

In your situation, your original investment loan was used solely to purchase an investment property. Therefore, the interest accrued on the loan has an income producing purpose and is deductible. You contributed $XX from your personal savings and transferred the amount to the bank to forward to the relevant parties at settlement. This amount is considered to be an additional payment towards the purchase of the property separate to the loan.

Regardless of the original purpose, use and application of the loan and shortfall amount, the redraw from your investment loan of $XX will be considered a new separate borrowing to the original loan and shortfall amount. You are intending to redraw the funds to help your daughter purchase her first home. This purpose is considered to be a private in nature as the funds are not being used to gain or produce your assessable income.

When you redraw the shortfall amount from your investment loan, your loan will become a mixed purpose account and there is an ongoing need to apportion interest on a fair and reasonable basis. Subsequent repayments are apportioned between the outstanding debt used at the time for income producing purposes and non-income producing purposes.

The ATO publication 'Rental properties 2021', page 16 (search QC 64907 on ato.gov.au) provides a comprehensive example on how to apportion the total interest accrued on a loan each year.

EXAMPLE 16: Apportionment of interest

The Hitchmans decide to use their bank's 'Mortgage breaker' account to take out a loan of $209,000 from which $170,000 is to be used to buy a rental property and $39,000 is to be used to purchase a private car. They will need to work out each year how much of their interest payments is tax deductible.

The following whole-year example illustrates an appropriate method that could be used to calculate the proportion of interest that is deductible. The example assumes an interest rate of 6.75% per annum on the loan and that the property is rented from 1 July:

Interest for year 1 = $209,000 x 6.75% = $14,108

Apportionment of interest payment related to rental property:

Total interest expense x rental property loan / total borrowings = deductible interest

Total interest expense x $170,000 / $290,000 = $11,475

You intend to use the redrawn funds from your loan for private purposes. Accordingly, the interest you incur on the redrawn amount will not be an allowable deduction under section 8-1 of ITAA 1997.

Other information

It is noted that the private ruling is to apply from the 20XX financial year and onwards. The Commissioner does not rule for indefinite or extended periods as there may be changes to the facts of the arrangement or the law in question. Also, a public ruling may issue which affects the private ruling. Therefore, we have only ruled for the 20XX to 20XX financial years.