Edited version of private advice

Authorisation Number: 1052222726476

Date of advice: 19 February 2024

Ruling

Subject: Rental - interest deductions

Question

Are the interest expenses deductible on the loan for Property Three after an error in the transfer of funds which incorrectly reduced the loan balance?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You, being Person One and Person Two owned a property (Property One) which was your main residence. The property was purchased in 20XX.

You sold Property One for $XXXX with settlement occurring on XX/XX/20XX.

You also owned an investment property (Property Two). This property was sold and settled on XX/XX/20XX.

You currently own an investment property (Property Three).

The three properties were covered by separate loans from Bank A held in joint names.

At the time of sale of Property One, there was less than $XXXX owing on the related Bank A loan.

The loan has been repaid in full.

On XX/XX/20XX, the amount of $XXXX, which was funds from the sale of Property One, was deposited into Bank A account number One.

On XX/XX/20XX, an amount of $XXXX was transferred from the real estate agent's trust account into Bank A account number One.

On XX/XX/20XX, you transferred $XXXX from the Bank A account number XXXX into the Bank A account number Two.

You provided the Bank A statement for account number XXXX for the period XX/XX/20XX to XX/XX/20XX showing these transactions. The description for the transaction on XX/XX/20XX says "To linked account XXXX - Off set".

You provided a copy of the Bank A account number Two statement for the period XX/XX/20XX to XX/XX/20XX. The statement shows the inbound transfer of $XXXX on XX/XX/20XX reducing the balance of the account to X.

On XX/XX/20XX, an amount of $XXXX was withdrawn from theBank A account number One to establish a term deposit with Bank A.

In XX/20XX, you entered a contract to purchase a new main residence (Property Four). Settlement occurred on XX/XX/20XX.

On XX/XX/20XX you transferred $XXXX from the Bank A account number Two to a new Bank A Offset Account number Three for the deposit and solicitor fee for the purchase of Property Four.

On XX/XX/20XX, you transferred $XXXX from the Bank A account number Two to the Bank A Offset Account number Three in preparation for settlement for the purchase of Property Four.

You provided a copy of the Bank A account number Two statement for the period XX/XX/20XX to XX/XX/20XX. The statement shows the withdrawals on XX/XX/20XX and XX/XX/20XX. The balance of this loan account at XX/XX/20XX was $XXXX.

You advised the balance of the Bank A Loan Account number Two at XX/XX/20XX was $XXXX.

You provided a copy of the Bank A Account number Four statement for the period XX/XX/20XX to XX/XX/20XX. This loan account relates to the purchase of Property Four. The balance of this loan at XX/XX/20XX was $XXXX.

You advised the balance of the Bank A Account number Four at XX/XX/20XX was $XXXX.

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.

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.

Taxation Ruling 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities considers the deductibility of interest incurred by borrowers on money drawn down under line of credit facilities and loans offering redraw facilities.

Paragraph 43 of TR 2000/2 states that the Commissioner considers a redraw from a loan account, to be 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. If this is for a non-income producing purpose, then the interest on the redraw amount is not deductible. The redraw facilities referred to in Taxation Ruling TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

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 further outlines that the deductibility of interest is determined by the purpose of the borrowing and the use to which the borrowed funds are put.

Taxation Ruling TR 93/6 Income tax and fringe benefits tax: loan account offset arrangements, outlines the Commissioner's view on loan account offset arrangements which are used to reduce the interest payable on a taxpayer's loan account. TR 93/6 provides that an acceptable loan account offset arrangement with dual accounts operates as follows:

•         There are two accounts - a loan account and a deposit account. It is accepted that where the deposit account is a sub-account, it will be treated as a separate account.

•         No interest is received on the deposit account.

•         The reduction of the loan account interest should be achieved by offsetting the balances of the two accounts.

A taxpayer with an acceptable loan account offset arrangement is entitled to claim a deduction for the full amount of interest incurred on the loan account, whilst the loan is used wholly for income producing purposes.

An offset account is a separate account and deposits to and withdrawals from an offset account will not change the character of the interest expense on the associated loan. The offset account is only a facility to reduce the amount of interest, being an outgoing, paid on the associated loan account.

Application to your circumstances

You have an investment loan with a financial institution. The initial loan funds were used to purchase an investment property (Property Three). You also had a loan to purchase your main residence (Property One) with the same financial institution.

Upon the sale of your main residence, you intended to transfer some of the funds from the sale into a loan offset account. Funds would then be withdrawn from the offset account and used to purchase a new main residence.

However, the funds were transferred to your investment property loan relating to Property Three instead of an offset account. Consequently, the loan was reduced to nil.

It was later that you discovered the funds were transferred, into the investment loan in error. It had always been your intention to maintain a loan on your investment property (Property Three) and not to pay this loan down.

Whilst the balance of your investment property loan relating to Property Three was reduced to nil. The account was not closed. XX/XX/20XX two withdrawals were made from the loan and deposited into a new offset account in preparation for settlement for your new main residence.

When you withdrew the funds in XX/20XX, the balance owing on the loan account was increased. As outlined in TR 2000/2, the redraw is considered a separate borrowing. The deductibility of the interest expense relating to the redrawn funds will be determined by the use of these funds. This is regardless of the original purpose of the loan funds.

The redrawn funds were deposited into an offset account in preparation for settlement for the purchase of your new main residence. Depositing funds into the offset account will decrease the interest payable on the related loan account but will not decrease the balance of the loan. The amount deposited is reflected as an increase in savings.

Conversely withdrawing funds from an offset account will increase the interest payable on the related loan account but will not increase the balance of the loan and is not a borrowing. The money withdrawn from the offset account is not in the form of borrowings and will not incur any interest. The amount withdrawn is reflected as a reduction in your savings. Any use to which these funds are put (including an income producing purpose) is funded by your savings and not a new loan.

The only benefit arising in the offset account is the right to ensure that the interest payable on the associated loan account is reduced. Therefore, the interest incurred on the redrawn amount does not have sufficient connection to gaining or producing assessable income. The essential character of the expense is considered private in nature. This is despite the fact the original purpose of the loan funds was for income producing purposes.

Whilst the investment loan for Property Three may have been reduced in error, having regard to all your circumstances, and based on the principles outlined in TR 2002/2, we do not consider that the redrawn funds were used for the purpose of gaining or producing assessable income. Therefore, the interest incurred on the new borrowed funds will not be deductible under section 8-1 of the ITAA 1997.