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.
Philip decides to borrow $300,000 with the intention that it will 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 the following:
- Carry out renovations
- Purchase depreciating assets (eg furniture),
- Make repairs or carry out maintenance
- 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 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.
Let’s assume that 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 takes note of 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 deductability 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 is 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
Where 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 principal ·
D = closing balance of total outstanding principal.
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