Edited version of private advice

Authorisation Number: 1052069247081

Date of advice: 21 December 2022

Ruling

Subject: Deduction - interest

Question

Can you claim a deduction for interest on Loan A?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You purchased a property (Property A) many years ago as joint tenants with your spouse. Property A was purchased using borrowed funds.

You moved out of Property A several years ago.

Initially, the mortgage on Property A was against a simple loan. At a later point in time, you refinanced to a line of credit loan.

Prior to 20XX, you had reduced the line of credit to a zero balance.

You lived in Property A from the time of purchase for many years.

At the time of moving out of Property A, you had drawn down the line of credit to an amount of approximately $XXX. This amount was used primarily for living expenses when you were out of work for several years.

You purchased another property (Property B) at the same time as you moved out of Property A. You moved into Property B upon purchase.

At the time of moving into Property B, Property A was valued at approximately $XXX.

Rather than selling Property A, you retained Property A to use for investment purposes.

You remortgaged Property A against a new loan for its valued amount (Loan A). Of that, $XXX was applied to the remaining line of credit mortgage for Property A and the remaining amount was applied to the mortgage for Property B (Loan B). This ensured that the debt to equity ratio on Property A was below the ratios required by the bank for an investment property.

The amount owing on Loan A was an amount that had been redrawn primarily for personal living expenses.

Once you moved out of Property A, you began using it to produce assessable income.

Relevant legislative provisions

Income Tax Assessment Act section 8-1

Reasons for decision

Question

Can you claim a deduction for interest on Loan A?

Summary

No.

Detailed reasoning

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.

For an expense to be deductible, you must incur the expense in the production of assessable income. The expense must also be incidental and relevant to the production of your assessable income. You must also demonstrate that there is a sufficient connection between the production of assessable income and the expense incurred.

To determine whether interest incurred on a loan is deductible, it is necessary to examine the purpose of the loan on which the interest is incurred, and also how the loan funds are used.

When you repay the principal on a line of credit loan, you are able to borrow a further amount equal to the difference between the reduced drawn-down amount and the available credit limit. That right to borrow further funds is a contractual right under the loan agreement permitting you to draw down funds up to the agreed credit limit.

When you do redraw on a line of credit loan, this will be considered a separate borrowing. To determine whether interest incurred on such a redraw is deductible, it will be necessary to look at how you use the redrawn funds. This is known as the use test and was outlined in Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, (1926) 32 ALR 339. In that case, it was held that the deductibility of the interest is determined by how you intend to use the borrowed money and is not determined by the security you give for the borrowed money. The nature of the security given is irrelevant to whether interest incurred is deductible.

To determine the deductibility of interest in relation to a line of credit loan, you also need to examine the ongoing application of the borrowed funds. Interest will be deductible under section 8-1 of the ITAA 1997 to the extent that you incur it on that part of the outstanding borrowed money used at that time for an income producing purpose.

Where you refinance to repay an existing loan, interest will only be deductible if the first loan was being used in an assessable income producing activity. The first loan must be being used in an assessable income producing activity at the time you obtain the new loan.

Application to your circumstances

Property A was purchased using borrowed funds. However, prior to 20XX, the line of credit amount on Loan A had been reduced to zero. Consequently, the borrowing that funded the purchase of Property A has been repaid.

From that point, any drawing down on the line of credit loan is considered a new borrowing for a new purpose.

You subsequently drew down amounts totalling approximately $XXX for living and other private expenses.

A new loan where the borrowed funds repay an existing loan (refinancing) is considered to be for the same purpose as the original loan.

The purpose of obtaining Loan A was to pay off the amount outstanding on the line of credit Loan and to ensure that you didn't have to pay mortgage insurance for Loan B on Property B. The line of credit was drawn down when you used Loan A to pay for living expenses. The remaining amount was used to assist with purchase of Property B, which is not used in the production of assessable income. Neither of these purposes relate to the earning of assessable income.

As neither the purpose nor use of the funds borrowed relates to the earning of assessable income, no deduction for interest on Loan A is available.