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Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for interest payments on a loan, where the proceeds of the loan are used to purchase their spouse's property, at market value, for the purpose of deriving rental income?

Yes. The taxpayer is entitled to a deduction under section 8-1 of the ITAA 1997 for the interest payments on a loan, where the proceeds of the loan are used to purchase their spouse's property, at market value, for the purpose of deriving rental income.

The taxpayer is an individual. The taxpayer's spouse owns a residential unit. The taxpayer's spouse does not have any outstanding debts in relation to this residential unit. The taxpayer takes out a loan equal to the market value of the spouse's unit and purchases the spouse's unit for the purpose of deriving rental income.

The interest expense (and other outgoings) associated with the residential investment units will outweigh the rental income, that is, the residential investment units will be negatively geared.

The taxpayer estimate that a 10% increase in the rental income would be needed to cover the expenses and expects that the rental market will cater for this in three to four years.

The term of each investment property loan is likely to be 10 to 15 years and repayments are interest only. The taxpayer expects to be a long term owner of the unit and would not sell the unit for at least 10 years.

Where a taxpayer is not carrying on a business, interest expense is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in gaining or producing assessable income and the expense is not of a capital, private or domestic nature.

The general principles relevant to the deductibility of interest expense are set out in Taxation Ruling TR 95/25. This Ruling provides that interest expense is incurred in gaining or producing assessable income and is not of a capital, private or domestic nature if the interest expense has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.

The character of interest on a loan is generally ascertained by reference to the purpose of the loan ( Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 ( Fletcher's Case )) and the use to which the loan is put ( Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153). Therefore, if a loan is used to purchase property from which income is to be derived, the interest paid on the loan is generally deductible.

Where the interest expense and other outgoings associated with the property is greater than the rental income to be derived, that is, where a property is negatively geared, 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.

In Fletcher's Case , the taxpayers entered into a negative gearing arrangement which was structured in a way that allows tax deductions to be obtained in the first 10 years. If the arrangement was allowed to run its full course, the arrangement would have generated substantial assessable income. The High Court remitted the matter to the AAT to determine whether, on a common sense assessment of all the evidence, the arrangement were intended and expected to run their full course. The AAT concluded that on the balance of probabilities the scheme was constructed on the premises that the arrangement would terminate before the first 10 years; that the taxpayer's advisers were fully aware of the consequences that would flow from a failure to terminate the arrangement before the 10 years; and the dominant purpose of the taxpayer was to minimise a possible tax liability.

Taxation Ruling TR 95/33 considers that negative gearing arrangements that are not intended to, and are not structured on the basis that they have a defined and pre-ordained period to run are not arrangements that fall within the scope of Fletcher's Case . It considers that in these cases, a commonsense or practical weighing of all of the factors could be expected to lead to the conclusion that the relevant interest expense is properly to be characterised as genuinely, and not colourably, incurred in gaining or producing assessable income or in carrying on a business for that purpose.

In this case, the taxpayer uses the loan to purchase a property, at market value, from the spouse, for the purpose of deriving rental income. The taxpayer estimates that a 10% increase in the rental income would be needed to cover the expenses, and expects the rental market to cater for this in three to four years. The taxpayer intends to be a long term owner of the property and does not have any plans to resell it for at least 10 years. The term of the loan is likely to be over 10 to 15 years. These factors indicate that the taxpayer's negative gearing arrangement does not fall within the scope of Fletcher's Case . The loan is used to acquire the property at market value. Therefore, it is irrelevant that the taxpayer's acquired the property from the spouse. Accordingly, a commonsense or practical weighing of all of the factors could be expected to lead to the conclusion that the relevant interest expense is properly to be characterised as genuinely, and not colourably, incurred in gaining or producing assessable income.

Therefore, the taxpayer is entitled to a deduction, under section 8-1 of the ITAA 1997, for the interest payments on a loan, where the proceeds of the loan are used to purchase their spouse's property, at market value, for the purpose of deriving rental income.