Interest can be claimed for the cost of funds borrowed to purchase a rental property and to meet maintenance costs or running expenses while the rental property is being let (or is available to be let) under a commercial arrangement to generate assessable income. 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.
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.
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 principal. 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.
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 taxpayer capitalises 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). Thus, the effect of the arrangement in this case is to re-characterise interest (on the home loan) that would have been otherwise non-deductible, as deductible.
When organizing this type of arrangement please remember that in some cases ATO may apply general anti-avoidance provision of the tax law to strike down the use of such a facility.
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.
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.
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.
From a tax perspective, the offset account arrangement provides a more flexible and favourable tax outcome where funds are accessed for private use.