1 Is the total interest you incur on the $X loan you obtained to pay out your former spouse deductible against your rental property?
1 No. Question 2 Is a portion of the total interest you incur on the $X loan you obtained to pay out your former spouse deductible against your rental property? Answer 2 Yes. This ruling applies for the following period: For the income year ending DDMMYYYY The scheme commenced on: DDMMYYYY
On DDMMYYYY, X (you) and your former spouse (X) purchased the property (the Property) situated at X as tenants in common holding X% and X% ownership interest respectively. You each owned your interests in the Property outright and there was no mortgage when you separated during the income year ended DDMMYYYY. Under the Family Law Act 1975 in the Federal Circuit and Family Court of Australia a court order (file no: X) dated DDMMYYYY was made by the Senior Judicial Registrar X between you and your former spouse. As per clause X of the court order, within 42 days of the order you were required to pay your former spouse $X. You made the payment by the due date and on DDMMYYYY, the remainder legal title to the Property was then transferred solely into your name. You obtained your former spouses X% ownership interest in the Property. The market value of the Property at that time was approximately $X. On DDMMYYYY you obtained a loan from a bank for $X, using the property as security for the loan. You will use the Property as a rental property to be occupied by holiday tenants from DDMMYYYY. Relevant legislative provision Income Tax Assessment Act 1997 section 8-1
Summary A portion of the interest incurred on the borrowed funds is deductible against the Property when you use the asset for the purposes of gaining or producing assessable income over the term of the loan. Detailed reasoning The deductibility of a loss or outgoing comprising interest under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) depends upon satisfying the words of the section, that is, being able to show that the loss or outgoing (or the part of the loss or outgoing in an appropriate case of apportionment) is: (a) red by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature or (b) sarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer. Whether or not a loss or outgoing incurred by a taxpayer satisfies the requirements of section 8-1 is dependent on all the facts and matters relating to the loss or outgoing in question. Taxation Ruling TR 95/25
Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith at paragraph 3 provides the Commissioner's view, along with case law and general principles relevant to the question on whether interest is deductible such as: (a) The interest expense must have 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.
(b) The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest. (c) A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity. Normally this would be the case for non-business taxpayers.
(d) A ridgid tracing of the borrowed money will not always be necessary or appropriate (e.g., where the borrowing finances the replacement of funds withdrawn from the business by a person entitled to be paid those funds). In such cases the relevant question is whether borrowed funds are being used to replace another source of funding for business purposes. (e) Interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets. (f) Interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity. (g) The interest will not be deductible, to the extent to which it is private or domestic in nature, or is incurred in relation to the gaining or production of exempt income. Application to your circumstances
In your case, you owned X% ownership interest in the Property since YYYY and prior to the relationship breakdown. You obtained X% ownership interest in the Property from your former spouse when you satisfied clause X of the court order and you paid them $X. The market value of the Property at that time was approximately $X, so the X% acquisition cost to you was $X. This amount forms part of your cost base or reduced cost base for capital gains tax (CGT) purposes. Therefore $X out of the $X loan funds were used for this purpose and only a portion of the interest incurred is deductible. It cannot be said that 100% of the interest of the loan is deductible simply because you've used the property as security over the loan and your objective purpose was to preserve the property to generate assessable rental income. This means only X% of the interest incurred on the loan is deductible against the Property when you use the asset for the purposes of gaining or producing assessable income over the term of the loan.
A rigid tracing of the borrowed funds shows that the remaining $X of the loan was used to settle with your former spouse which is private or domestic in nature. This expenditure is not deductible under section 8-1 of the ITAA 1997. You must apportion the interest charged on the loan over the term of the loan when you calculate a rental property interest deduction.