Timing of deduction for prepaid interest

Is the deductibility of prepaid interest, paid by an individual taxpayer in respect of a rental property for a period not exceeding 12 months, subject to special timing rules under section 82 KZM of the Income Tax Assessment Act 1936 (ITAA 1936)?

No. The deductibility of prepaid interest, paid by an individual taxpayer in respect of a rental property for a period not exceeding 12 months is not subject to special timing rules under section 82 KZM of the ITAA 1936.

The individual taxpayer owns a residential rental property. The taxpayer borrowed money to purchase the property. The loan is used solely for income producing purposes. The taxpayer incurs an interest expense under the loan.

The taxpayer is not in a rental property business.

The taxpayer intends to pay one full year's interest in advance on the loan in the current financial year.

The prepaid interest is more than $1000.

By paying the interest in advance, no interest will be payable in the following year.

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, or are necessarily incurred in carrying on a business for the purposes of gaining or producing such income, except where the outgoings are of a capital, private or domestic nature, or relate to the gaining or production of exempt income.

The loan interest is an allowable deduction under section 8-1 of the ITAA 1997. However as this is a prepayment of the interest expense the application of section 82KZM of the ITAA 1936 must be considered.

The effect of section 82KZM of the ITAA 1936 is to evenly spread the deduction for prepaid interest over the years comprising an 'eligible service period'. The 'eligible service period' is the period to which the interest relates, not the term of the loan, being a period not exceeding 10 years (subsection 82KZL(1) of the ITAA 1936).

A prepaid expense will not be subject to these timing rules where the following factors exist: • the interest is otherwise deductible under section 8-1 of the ITAA 1997; • the taxpayer is an individual; • the expenditure was not incurred in carrying on a business; and • the eligible service period is 12 months or less.

The taxpayer is an individual who is not carrying on a business. The interest expense would be deductible under section 8-1 of the ITAA 1997 and the 'eligible service period' is 12 months or less. Accordingly, the interest is not subject to the timing rules in section 82KZM of the ITAA 1936 and is deductible to the taxpayer in the year in which it is incurred.