In these circumstances the interest paid is deductible even if it exceeds the income generated. The deductibility of interest is to be determined from the purpose for the borrowing and the use to which the borrowed funds are put.
Philip borrows $300,000 with the intention that it be used to acquire a unit in a new apartment building. He intends to lease the unit out to derive rental income. The builder has financial difficulties and Philip is able to acquire the unit for $275,000, which he then makes available for rental. Philip uses the balance of $25,000 to have an extended overseas holiday.
Philip would be entitled to deduct interest applicable to the $275,000 because it will be incurred in gaining assessable income. The interest applicable to the $25,000 will not be deductible because it is used for private purposes. That is so even though it was originally borrowed to acquire the unit.
A deduction for interest is also available on a loan taken out to:
carry out renovations
purchase depreciating assets (e.g. furniture)
make repairs or carry out maintenance, and
purchase land on which to build a rental property.
Redraw on an existing loan
It is common practice for financial institutions to offer redraw facilities against existing loans. Under this loan facility, a borrower may redraw previous repayments of a loan principle. The loan may be for income producing purposes, non-income producing purposes or mixed purposes. In this case, the interest on the loan must be apportioned into deductible and non-deductible components in accordance with the amounts borrowed for the rental property and for private purposes. This is best illustrated by example.
George borrows $250,000 from a bank to buy a house, which is rented out. After five years of renting out the house, the balance owing on the loan is $120,000. The bank notes George's excellent repayment record and asks whether he might like to re-borrow against the house for other purposes. George does so, drawing down $50,000 to buy a car (private use only) returning the account balance to $170,000.
George wants to claim a tax deduction for all of the interest on the loan on the basis that the loan was originally taken out to acquire the rental property. However, George can only claim interest on the loan of $120,000 because the $50,000 loan was for private purposes. Any interest paid in the future will be apportioned between the percentage applicable to the rental property (deductible) and that applicable to the car (non-deductible). The original application of the borrowed funds will not determine deductibility where funds borrowed under a line of credit have been recouped or withdrawn from the original use and are reapplied for a new use. This might also occur upon sale of an asset purchased with borrowed funds.
Given the difficulties in apportioning interest that accrued on a daily basis, the ATO generally accepts a monthly calculation using an apportionment approach based on the average outstanding principal used that month for income producing purposes. This is calculated as follows:
Total interest accrued for the month x Deductible interest %
The deductible interest percentage is calculated as follows:
(A + B) ÷ (C + D) x 100
A = opening balance (beginning of month) of outstanding principal used for income producing purposes
B = closing balance (end of month) of outstanding principal used for income producing purposes
C = opening balance of total outstanding principals
D = closing balance of total outstanding principals
Split or linked loans
According to the relevant legislation, a linked loan is "a credit facility taken out with a financial institution under which there are two or more loans with an account being maintained in respect of each loan." A split loan is "a credit facility taken out with a financial institution under which there is one loan with sub-accounts being maintained in respect of that loan."
The outcome of a particular court case was in one instance cited by the ATO in order to apply a general anti-avoidance provision of the tax law to strike down the use of such a facility in the manner adopted by the taxpayer in that case. The taxpayer capitalised interest accruing on the investment component of the loan and applied all cash to the repayment of the private component (the interest in respect of which was non-deductible).
Therefore anyone taking out a loan to purchase a rental property should carefully consider their financing arrangements. In particular avoid the mixing of accounts that have both deductible and non-deductible components. Professional advice should be sought before signing up to the loan as it is difficult to unwind arrangements that may turn out to be non-effective for tax purposes.
Loan account offset facility
Where the facility constitutes an acceptable "loan account offset arrangement", the availability of an interest deduction where funds are withdrawn for a private purpose differs to that of a redraw facility.
According to an ATO ruling, under a loan account offset facility arrangement, the borrower typically operates two accounts:
a loan account, and
a deposit account.
There is no entitlement to receive interest payments or payments in the nature of interest on the amounts credited to the deposit account. The reduction in the loan account interest is achieved by offsetting the balances of the two accounts.
As a general rule, the ATO considers that a taxpayer with an acceptable loan account offset arrangement with dual accounts is entitled to claim a deduction for the full amount of interest while the loan is used wholly for income producing purposes. Any reduction to the interest payable would typically not be assessable as no amount of interest has been received or credited to the borrower. Significantly, in a number of private rulings the ATO accepts that interest on the loan account will remain fully deductible if funds are withdrawn from the "deposit account" and used for non-income producing purposes. The Commissioner's rationale for this position is that:
depositing funds into the deposit account will decrease the interest payable on the loan account but will not decrease the balance of the loan account, and
withdrawing funds from the deposit account will increase the interest payable on the loan account but again, will not impact the loan balance.
From a tax perspective, the offset account arrangement provides a more flexible and favourable tax outcome where funds are accessed for private use. Essentially, taxpayers will need to evaluate these facilities in line with their commercial objectives.
On 1 July 2016, Jimmy acquired a rental property that was funded by way of a 25 year loan. The initial loan amount was $300,000 and provides a loan offset facility such that any repayments can be made to deposit account. Interest is charged at the end of the month on the net balance between the loan account and the deposit account. During the 2015-16 income year, Jimmy made total repayments of $100,000 into the deposit account. Interest will be charged on the net amount of $200,000 (net balance between the loan account and the offset account), and Jimmy can deduct interest incurred on the net balance.
Subsequently, on 1 July 2017, Jimmy redrew an amount of $100,000 from the deposit account to fund the purchase of a private motor vehicle. Provided that no repayments were made to the deposit account during the 2015-16 income year, Jimmy is entitled to a deduction for the interest incurred on the entire loan balance of $300,000.
Penalty interest rates
Penalty interest payments are typically considered to be a mortgage discharge expense.
The ATO accepts that penalty interest payments on a loan relating to a rental property are deductible when:
the loan is secured by a mortgage over the rental property and the payment effects the discharge of the mortgage, or
the payment is made so as to remove a recurring obligation of the taxpayer to pay interest on the loan.