Private ruling: Rental property expenses - Interest
Date of advice: 11 December 2015
Published: February 2016
Ruling period: Year ending 30 June 20XX | Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Can you claim a deduction for the interest expenses incurred on your investment loan for the portion of the refinanced loan used to pay the balance payable in relation to your investment property loan? | A1: Yes. | Q2: Can you claim a deduction for the interest expenses incurred on your investment loan for the portion of the refinanced loan used to pay your former spouse? | A2: No. | Q3: Can you claim 100% of the interest expenses on your rental property even though the mortgage is held in joint names with another person? | A3: Yes.

Relevant facts and circumstances: You purchased a rental property in 200X. Your name alone was on the title and mortgage documents. You refinanced the loan for the investment property with your partner in 20XX. The loan was an investment loan for the rental property. Your partner's name was added to the mortgage but the title of the property remained solely in your name. You separated from your partner in 20XX. You alone have been paying the property expenses, including the mortgage payments, since mid 20XX. You now intend to refinance your loan for a larger amount in order to transfer the investment loan solely to your name and make a payment your partner. The payment to your former spouse, which equates to 50% of your current equity in the property, will be made as part of a settlement agreement.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision: Summary: 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. | Detailed Reasoning - Question 1 and 2: Taxation Ruling TR 95/25 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. Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. Further, interest on a new loan used to repay an existing investment loan will generally also be deductible as the character of the new loan is derived from the original borrowing. That is, when a loan is refinanced, the new loan takes on the same character as the previous loan. Refinancing a loan does not in itself break the nexus between the outgoings of interest under a loan and the income earning activities. However, if the taxpayer keeps the loan on foot for reasons not associated with the former income earning activities; or extends the loan for reasons unrelated to earning assessable income as the original loan was, the nexus between the outgoings of interest and the relevant income earning activities will be broken. You intend to refinance your jointly held loan for your investment property. By refinancing you will establish a new residential investment loan in your name to pay out the jointly held investment loan and to pay an amount to your former spouse as part of a settlement agreement. The portion of the funds borrowed to make a payment to your former spouse as part of a settlement agreement will not be used for an income producing purpose. Accordingly, interest expenses incurred on that portion of the loan is not deductible under section 8-1 of the ITAA 1997. The portion of the funds borrowed to refinance the existing investment loan will take on the character of that loan as being used for an income producing purposes. Therefore, the interest expenses incurred for that portion of the loan are an allowable deduction under section 8-1 of the ITAA 1997. | Detailed Reasoning - Question 3: Taxation Ruling TR 93/32 explains that the net loss or income from a rental property must be shared according to the legal interest of the owners, except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title. An example of where the equitable interest may differ from the legal interest is when an owner is holding their share as trustee for the other owner. A Family Court order dealing with settlement of jointly owned property may also alter this equitable interest. A person's legal interest in a property is determined by the legal title to that property under the land legislation in the State or Territory in which the property is situated. The legal owner of the property is recorded on the title deed for the property issued under that legislation. Rental income and expenses must be attributed to each co-owner according to their legal interest in the property, despite any agreement between the co-owners, either oral or in writing stating otherwise. Where a co-owner forgoes their share of the rental income and/or pays for all the expenses this is considered to be a private arrangement between the co-owners. It does not alter the fact that they are legally entitled to their share of the income and liable for their share of the expenses. In your case, you are the sole holder of the title of the property and hold the legal interest in the property. Therefore, you are entitled to claim 100% of the interest deductions with respect to the rental property. Although the mortgage is in both names, there is nothing in the legislation which allows a choice to allocate income and expenses on a basis different to the legal title.