Edited version of private advice

Authorisation Number: 1052326863629

Date of advice: 1 November 2024

Ruling

Subject: Rental deductions

Question

Can you claim interest deductions against the $15,000 that was remaining on the home loan against the Property A, when you used the existing funds to purchase a new primary residence, pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You have a permanent disability.

In 20XX, you and your spouse purchased a land and house build (Property A).

The loan on Property A is $XXX,XXX.

You made additional payments against Property A, resulting in $XXX,XXX sitting in a redraw facility.

In XX 20XX, you and your spouse purchased a new property (Property B).

The purchase of Property B was to include the $XXX,XXX amount that you had in your redraw facility.

Shortly before settlement of Property B, you were informed that $XXX,XXX of your funds in the redraw facility had been consolidated against Property A.

Property A is now your investment property.

Property B is your primary residence.

A large debt has been established against Property B.

Your intention was for the larger debt to be against Property A, to allow for interest deductions against the assessable income you now earn from Property A.

At the time of purchasing Property A, you were not prepared to establish separate offset accounts as this would have involved changing bank providers or making constant bank transfers that would have complicated your disability support pension.

You now believe that if you had established offset accounts on acquisition of Property A, this would have allowed for a more efficient debt structure.

Following the refinancing of the home loans, your current debt structure against each property is:

•                     Property A has a loan balance of $XXX,XXX

•                     Property B has a loan balance of $XXX,XXX.

On reflection, you have stated that the debt structure against each property should have occurred as follows:

•                     Property A should have had a loan balance of $XXX,XXX

•                     Property B should have had a loan balance of $XXX,XXX.

When you refinanced, your previous home loan against Property A, the remaining amount owing to the bank was $XX,XXX.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question

Can you claim interest deductions against the $XX,XXX that was remaining on the home loan against Property A, which is now a rental property, pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

Section 8-1 of the ITAA 1997 allows you to claim interest deductions against the $XX,XXX that was remaining on the original Property A home loan, whilst the loan is used for income producing purposes.

Detailed reasoning

Section 8-1 of the 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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

•                     it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478),

•                     there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

•                     it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling TR 95/25 Income tax: deductions for interest under subsection 51(1) of the Income Tax Assessment Act 1936 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.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Where borrowing is used to acquire income producing assets or relates to an income producing activity, the interest on the borrowing is considered to be incurred in the course of producing assessable income.

This remains so even where you change the security for the loan. The deductibility of interest is determined by the use for which the borrowed money is intended and not by the security given for the borrowed money as detailed in Taxation Determination TD 93/13 Income tax: is interest paid on a loan used to acquire income producing property an allowable deduction where non income producing property (e.g. the family home) is used as security for the loan? The nature of the security (if any) given for the loan is irrelevant in determining the deductibility of interest (Munro's case). The security is simply a surety to the bank in case of default of the loan and does not alter the use of the loan funds.

The use is also not altered in the case of a refinance. Paragraph 42 of TR 95/25 addresses borrowings used to repay an existing loan. The paragraph states "Interest on a new loan will be deductible if the new loan is used to repay an existing loan, which, at the time of the second borrowing, was being used in an assessable income production activity or used in a business activity which is defined to the production of assessable income (Roberts and Smith ATC at 4388; ATR at 504).

Taxation Ruling TR 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.

The ruling establishes drawing any excess or available funds from a loan account is treated as a new loan. As such the purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use to which the redrawn funds are put. This is independent of the purpose of the original borrowing. 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 TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

Application to your circumstances

You consulted a mortgage broker and tax agent and signed loan documents to use the available funds in the redraw facility linked to Property A. The funds you redrew are considered a new borrowing of funds and were used to reduce the loan against Property A, leaving a loan balance of $XX,XXX. Property A was then used as security to allow you to obtain Property B, which is now your main residence.

The redraw of funds against Property A is considered a separate borrowing action and therefore, the deductibility of interest on that separate borrowing depends on whether the interest is incurred in gaining or producing assessable income.

Property A is now used as a rental property, allowing you to produce assessable income against Property A, the associated interest expenses you are incurring on Property A are deductible pursuant to section 8-1 of the ITAA 1997.