Edited version of private advice

Authorisation Number: 1052082685905

Date of advice: 31 January 2023

Ruling

Subject: Deductions for interest expenses - rental property

Question 1

Can you deduct your share of the interest they incur on Loan 2 against rental income from Property 1 under section 8-1 of the Income Tax Assessment Act (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Income Year Ending 30 June 20XX

Income Year Ending 30 June 20XX

Income Year Ending 30 June 20XX

The scheme commenced on:

22 June 20XX

Relevant facts and circumstances

Prior to the start of the Ruling period, A (you) and your spouse owned properties financed via loans with D Bank as shown in the following table:

Property 1 has been used to produce assessable income since the date of purchase. You and your spouse have no plans or intentions to sell Property 1 in the near future. Your current intention is to generate income from the property throughout the ruling period.

Loan 1 was taken out to purchase Property 1. It was never used to refinance any pre-existing loans.

Property 2 was your primary place of residence for a period of about 17 months from the acquisition date. Then you and your spouse moved to an alternate primary residence.

Property 2 was then rented out and remained an income producing asset until the date of sale.

You and your spouse borrowed funds from E Bank to purchase Property 2 (Original Loan). Loan 2 was taken out later with D Bank to refinance Property 2, and the funds were used to pay out the Original Loan.

In the ruling year, you and your spouse sold Property 2. Your intention was:

•         to use the proceeds of the sale to pay out Loan 2, and

•         to transfer the remaining balance into your private account.

However, when your "Discharge Authority for Sale of Property and Loan Repaid" form was signed, the incorrect loan account number was recorded on the form. D Bank closed Loan 1 instead of Loan 2 following the incorrect instruction on the form.

You approached D Bank about the error, but they did not need to rectify the error and maintain Loan 2, holding the mortgage over Property 1.

There have been no redraws on either Loan 1 or Loan 2 at any time.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Summary

The interest on Loan 2 is incurred in producing your assessable income from renting Property 1 and is not private or domestic in nature. As such, you can deduct your share of the interest on Loan 2 from your assessable income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Reasons for decision

Section 8-1 of the ITAA 1997 allows a deduction for 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.

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 (TR 95/25) provides the Commissioner's view on the deductibility of interest expenses following the Full Federal Court decision in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith).

Paragraph 3 of TR 95/25 sets out the general principles relevant to the question of whether interest is deductible under section 8-1 of the ITAA 1997:

•         There must be a sufficient connection between the interest expense and the activities which produce assessable income. The test is one of characterisation, and the essential character of the expenses is a question of fact to be determined by reference to all the circumstances.

•         The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower (the use test).

•         Regard must also be had to all the circumstances, including the objective purpose of the borrowing and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, your subjective purpose, intention or motive may be relevant (the 'purpose' test).

A rigid tracing of the use or application of the borrowed money will not always be necessary or appropriate (TR 95/25 paragraph 3) and will not necessarily be determinative (TR 95/25, paragraph 27).

As explained in paragraph 42 of TR 95/25, interest on a new loan that is used to pay out an existing loan will be deductible if, at the time of the second borrowing, the existing loan was being used in an assessable income producing activity.

Guidance on rental property deductions and claiming interest expenses can be found on the ATO website, ato.gov.au, at the following pages:

•         Rental properties 2022, using quick search code QC 68022,

•         Rental expenses you can claim now, using quick search code QC 23635.

Rental properties 2022 says:

Some rental property owners borrow money to buy a new home and then rent out their previous home. If there is an outstanding loan on the old home and the property is used to produce income, the interest outstanding on the loan, or part of the interest, will be deductible. However, an interest deduction cannot be claimed on the loan used to buy the new home because it is not used to produce income. This is the case whether or not the loan for the new home is secured against the former home.

Rental expenses you can claim now provides the following example:

Zac and Lucy take out a $400,000 loan secured against their existing property to purchase a new home.

Rather than sell their existing home they decide to rent it out.

They have a mortgage of $25,000 remaining on their existing home, which is added to the $400,000 loan under a loan facility with sub-accounts - that is, the two loans are managed separately but are secured by the one property.

Zac and Lucy can claim an interest deduction against the $25,000 loan for their original home as it is now rented out.

They can't claim an interest deduction against the $400,000 loan used to buy their new home as it's not being used to produce income even though the loan is secured against their rental property.

In your circumstances

As detailed in the Relevant facts and circumstances, until the date of sale you and your spouse earned assessable income from renting out the land and buildings at Property 1 and Property 2. You and your spouse acquired the properties using the following funds:

•         Loan 1 to purchase Property 1, and

•         Original Loan to purchase Property 2.

Later Loan 2 was used to pay out Original Loan.

You have used Property 1 to produce assessable income since the day it was acquired and intend to continue to do so, at least throughout the ruling period. Property 1 has never been used for private or domestic purposes.

Although Property 2 was initially used for private and domestic purposes for 17 months following acquisition, subsequently it was used solely to produce assessable income. It is accepted that during the latter period the Original Loan was used in an income-producing activity.

Neither Loan 1 nor Loan 2 have been used to fund any private or domestic needs, or any other non-income producing needs. No redraws have been done on any of the above loans.

You sold Property 2. Contrary to your intentions, on the day of settlement the sale proceeds were used by the bank to pay out Loan 1, instead of Loan 2. It is accepted that, since the date of settlement, the bank continues to provide the finance under Loan 2 for use as ongoing finance for Property 1.

You have used Property 1 solely to produce your assessable rental income and intend to continue using the property for this purpose throughout the ruling period.

As such, it is considered that the interest on Loan 2 is incurred in producing your assessable rental income and is not private or domestic in nature. Your share of the interest on Loan 2 is deductible under section 8-1 of the ITAA 1997.