Private ruling: Income tax - deductions - rental property expenses - interest expenses
Date of advice: 23 March 2018
Published: June 2018
Ruling period: Year ended 2018 | Year ended 2019 | Year ended 2020
Date scheme commenced: 1 July 2017

Ruling: Q1: Are you entitled to claim a deduction for interest incurred on the new loan to the extent it repays the loan that was used to finance the purchase of Property B? | A1: No. | Q2: Are you entitled to claim a deduction for interest incurred on the new loan to the extent it repays the loan that was used to finance the purchase of Property A? | A2: Yes.

Relevant facts and circumstances: You acquired your principal place of residence at suburb A in year 20xx (Property A). You currently reside at Property A. You purchased another property at suburb B. There was a mortgage on Property B. You bought Property B for investment purposes. The property is genuinely available for rent; however, it is currently without a tenant. You will move to Property B and make it your principal place of residence. You will rent out Property A and make it your investment property. Property B and Property A currently have an outstanding mortgage. One new bank loan (new loan) will be used to pay out the existing loans. This loan will be secured by a mortgage over Property A. This strategy will result in you living in an unencumbered Property B.

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

Reasons for decision: Summary: The interest payments you will make on the funds to be advanced by a mortgage over your rental property are only deductible to the extent to which they will be incurred in gaining or producing assessable income. | Detailed Reasoning - Detailed Reasoning: Under the provisions of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income. However, you cannot deduct a loss or outgoing to the extent that it is of a capital, private or domestic nature. If a loan is taken out to purchase a rental property, the interest charged on that loan, or a portion of the interest, can be claimed as a deduction. The property must be rented, available for rent, or intended to be rented in the immediate future, in the income years for which the deduction is claimed. Rental deductions can be claimed against the receipt of rental income as expenses incurred in earning assessable income under section 8-1 of the ITAA 1997. Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153 ( Munro’s case ), is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest will be deductible to the extent that the property is used to produce 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 (Taxation Determination TD 93/13). 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 your financier in the case of default of the loan and does not alter the use of the loan funds. This use is also not altered in the case of a re-finance. Taxation Ruling TR 95/25 examines, amongst others, this circumstance. Interest on a new loan which was to used to repay an existing loan will be deductible if, at the time of second borrowing, the fund was being used in an assessable income producing activity. Taxation Ruling TR 95/33 requires an examination of all the circumstances surrounding the expenditure to ensure that the interest expense could be properly characterised as genuinely, and not colourably, incurred in gaining or producing the assessable income. Interest may be incurred on loans for more than one purpose, in which case it may be necessary to apportion the interest payments for calculating deductibility of the interest . In Munro’s case , the High Court also considered whether interest incurred on a borrowing which was not used to produce assessable income, but was secured by an income producing asset, was deductible. The taxpayer argued that if the interest obligations were not discharged, the income producing asset that secured the borrowing would be in jeopardy. Thus, the discharge of the obligation to pay interest was incurred in producing assessable income. The High Court rejected this proposition. In Case B11 (1970) 70 ATC 46 (Case B11), the taxpayer purchased a new home (B) with borrowed moneys after having decided to retain ownership of his former home (A) with a view to leasing it. He borrowed moneys on the security of both properties. The loan amount was applied towards purchasing B and renovating/extending A. In assessment, the Commissioner disallowed the claim for deduction on interest, but upon objection allowed interest attributable on an apportionment basis for the bank loan which had been expended on A. The taxpayer lodged an objection to the Taxation Board of Review claiming that he is entitled to a deduction on the balance of the interest. The Board confirmed the Commissioner’s assessment. In Case 12/95 (1995) 95 ATC 175; (1995) 30 ATR 1169 (Case 12/95) , the applicants, a husband and wife acquired and moved into a new main residence in Adelaide. They claimed deductions on interest and borrowing expenses from the purchase of this new property against income from renting their previous unencumbered residence in Sydney. The deduction sought on the mortgage interest was disallowed. In your case, the loan will be taken out for two purposes, one for your residence and one for your rental property. Only a proportionate part of the interest to be incurred is allowable where the borrowing is partly for income producing and partly for other purposes. Accordingly, it is necessary to apportion the interest payments to be incurred on your new loan. | Detailed Reasoning - Property B: The first purpose of the loan is to discharge the existing mortgage over your untenanted Property B rental property. As this property will now be your principal place of residence, the loan is considered to be used for private or domestic purposes. The borrowing will enable you to acquire ownership of a private home but not to gain or produce assessable income. Regardless of the loan being secured by your future rental property at Property A, the interest on that portion of loan moneys laid out for a non-allowable purpose will not be deductible. | Detailed Reasoning - Property A: The second purpose of the loan is to re-finance the existing mortgage over your residence. With re-finances, the borrowings for repayment of the original loan retain the use or purpose attributed to the purchase of the property. However, as this property will now be your future rental property, the loan is considered to be used in gaining or producing your assessable income. The interest on that part of the bank loan laid out for the purpose of re-financing a future income producing asset will be allowable as a deduction.