[Tax] Interest deduction strategy for your investment property

Australian residential property owners may have experience drawing money from their home loan accounts. Usually, you will be entitled to a deduction for the interest on the redrawn amounts from your home loan redraw account where the redrawn amounts were used to purchase your investment property.

1. Example

For example, if you have a home loan with a redraw facility, and you used available funds from the redraw account to purchase an investment property (i.e. to fund 20% of the purchase price and costs associated with the purchase). For the rest of the 80% of the purchase price, you will seek a new mortgage loan. In this regard, you would purchase an investment property without using any of your cash on hand.

In practice, you can transfer the offset account balance to the redraw account, and then you pay for the 10% deposit from the redraw account. You will then transfer the available redraw amount from the redraw account to pay the remaining 10% of the purchase price and the costs associated with the purchase of the investment property.

2. Tax benefits

   
   

As you have used the redrawn funds for income-producing purposes, this is generally considered a new loan. As per TR 2000/2, you are entitled to a deduction for the interest on the redrawn amounts. However, as the original home loan is now a 'mixed purpose' loan, you will need to apportion the interest for income-producing and private purposes.

The redrawn funds were transferred into an offset account and a savings account, which were then used to pay the deposits for the investment property. As the funds originally came from the redraw facility, the interest remains deductible.

3. Tax legislations

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, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

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 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. However, where a loan relates to private purposes, no deduction is allowed.

Taxation Ruling TR 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities considers the deductibility of interest incurred by borrowers on money drawn down under line of credit facilities and loans offering redraw facilities.

The ruling establishes that drawing any excess or available funds from a loan account is treated as a new loan. As such the purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use to which the redrawn funds are put. This is independent of the purpose of the original borrowing. The redraw facilities referred to in TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

Where a person uses the redrawn funds for different purposes then the loan account becomes a mixed purpose account. In a mixed purpose loan, the interest must be apportioned between the income producing and non-income producing purposes. The part of the accrued interest attributable to the funds used for private purposes is not deductible.

Reference: ATO

Disclaimer: This article is intended to provide general information only and does not constitute professional advice for specific circumstances.  It should not be relied upon as a substitute for tailored advice.