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Can you still claim the main residence exemption while tax deducting your home loan?
Tax Deducting Your Home Loan
When you rent out your main residence, can you tax deduct your home loan? And if you can, can you still claim the 6-year absence rule for the main residence exemption, so basically pay no CGT on the capital gain but still claim the interest while you are renting it out?
That is the question Andrew Henshaw of Velocity Legal in Melbourne will discuss with you in this episode.
Here is what we learned but please listen in as Andrew explains all this much better than we ever could.
Tax Deducting Your Home Loan
There are two schools of thought. The first one is very strict and just looks at the original purpose of the loan. This is the position taken in ep 266. That school basically says that once a private purpose, always a private purpose.
But there is another, a lot more lenient interpretation, referring to TR 2000/2. And this is the angle we will look from in this episode.
Clear Yes or No Scenarios
But first, let’s look at five scenarios that are a clear Yes or No under either school of thought, so it doesn’t matter which angle you take.
1 – Redraw
If you pay off your mortgage and then redraw again from the same mortgage, still with your home as security, but the redraw is now for an investment purpose, then you can tax deduct the interest
2 – Split
If you split your current mortgage and allocate one part to your home and one part to your investment asset you can tax deduct the interest, but only the portion for your investment asset.
3 – Separate Investment Loan with Home as Security
You could leave your mortgage as is and get a separate investment loan – possibly with your home in the asset pool held for security – and then you can tax deduct the interest for the investment loan.
4 – Offset
Let’s say your mortgage is $3m and you have $3m in your offset account. So fully paid off. No interest. Now you withdraw the $3m to buy an investment asset. Can you tax deduct the interest?
You can’t because offset and mortgage are two separate accounts. The offset account is a savings account. And the mortgage is – well – a mortgage. And your mortgage is for your home, so no tax deduction is available, even if you use your offset to invest.
Repurpose of Loan
But now let’s come to the scenario that is hotly disputed. You buy a home and take out a mortgage but then you move and rent out your home. So yes, originally the mortgage was for a private purpose but now it is covering an asset that is deriving income. So can you tax deduct the interest?
In ep 266 Geoff Stein said No and argued that the mortgage was taken out for a main residence, a private purpose, hence not deductible even when rented out. That is quite a harsh approach. So we looked into this again and spoke with Andrew Henshaw.
General Concepts
Let’s start with the basics – s8-1 ITAA 97. Can you tax deduct the interest for a capital asset? The answer is yes since it is incurred to gain assessable income. Even if the asset never actually incurs assessable income.
This is supported by the Steele’s case that went all the way to the High Court. (STEELE v FC of T 97 ATC 4239, Federal Court of Australia, Full Court, 18 March 1997 and STEELE v DFC of T 99 ATC 4242, High Court of Australia (Full Court), 04 March 1999).
So interest is ordinarily deductible, even if used to purchase a capital asset.
Purpose of the Borrowing
Generally, you determine the purpose of the borrowing from the use of borrowed funds and outgoings of interest ordinarily draw their character from that use (Fletcher v. Federal Commissioner of Taxation (Fletcher) (1991) 173 CLR 1; 91 ATC 4950; [cited in TD 2008/27]
In Hill J in HART & ANOR v FC of T 2002 ATC 4608, Federal Court of Australia, Full Court, 26 July 2002 two tests have been proposed to determine the deductibility of interest on monies borrowed to acquire income-producing assets.
The first looks to the purpose of the borrowing. The second looks to the use of the borrowed funds. Generally, both tests give you the same answer.
Change of Purpose
What if the use of the asset changes? So originally it was a home loan but now you rent it out. In ep 266 we said that this doesn’t matter. If taken out for a private purpose, then always a private purpose.
But there is the decision of Edmonds J in Spassked Pty Ltd v. Commissioner of Taxation (Spassked) (2007) 165 FCR 484; [2007] FCAFC 205; 2007 ATC 5406; (2007) 67 ATR 900 that deductibility of interest is not always determined only by the use or the initial use of the borrowings on which the interest arises.
The issue of deductibility of interest on a loan ‘is essentially a question of fact in respect of the year or years of income for which it is to be determined. Moreover, it is clear that the relevant factual considerations can change over the term of the loan so that the facts relevant to the criteria for deductibility in one year will not necessarily mirror those in another year.”
And following this TD 200827 says that it “is also possible that even within a given income year the purpose or use of a loan can change from non-income producing to income producing or vice versa.”
Ordinarily “…the purpose of the borrowing will be ascertained from the use to which the borrowed funds were put…” (Hill J in Kidston Goldmines Limited v FC of T 91 ATC 4538 at 4545; (1991) 22 ATR 168 at 176) and in FC of T v JD Roberts; FC of T v. Smith 92 ATC 4380 at 4388; (1992) 23 ATR 494 at 504, “…a rigid tracing of funds will not always be necessary or appropriate…”.
Interest Before and After
Thus far we spoke about the interest during the income earning activities. But about before and after?
TR 2004/4 says that you usually can’t tax deduct before and after interest because the interest is not incurred in gaining or producing the assessable income of that period or any future period.
However, if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period, then you can still tax deduct the interest. So you need to look for the nexus between the outgoing and the income-earning activities.
An outgoing of interest in such circumstances will not fail to be deductible merely because:
- the loan is not for a fixed term;
- the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or
- the original loan is refinanced, whether once or more than once.
However, if the taxpayer:
- keeps the loan on foot for reasons unassociated with the former income earning activities; or
- makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred,the nexus between the outgoings of interest and the relevant income earning activities will be broken.
New Asset
What about you recoup your investment and put it into a new investment? It all depends on what you are currently using the funds for as per TR 2000/2.
“The deductibility of the interest is determined by considering the application of the borrowed funds for income-producing and non-income-producing purposes. The original application of the borrowed funds will not determine deductibility where funds borrowed under a line of credit facility have been recouped or withdrawn from the original use and are reapplied to new use, eg on sale of an asset purchased with borrowed funds.”
However, the original purpose of the borrowing and use of the borrowed funds will not always determine the deductibility of interest. Where borrowed money has been used to purchase an income-producing asset and that asset subsequently has been sold, the original use of that money will not necessarily determine the character of the interest expense accruing on those borrowed funds.
In such a case the question of the deductibility of interest “… must be resolved by determining whether the essential character of the interest outgoings after the sale… was such that it can be said that those outgoings were incurred by the respondent in the course of the gaining or production of assessable income or, having regard to the business then carried on by it, they were necessarily incurred by the respondent in carrying on that business.” (FC of T v Riverside Road Pty Ltd (in liq) 90 ATC 4567 at 4576; 21 ATR 499 at 509).
Example
Here is the example we use in the interview.
William (Bill) is a computer programmer. He is offered a job in Darwin and decides to relocate his family there, borrows $200,000 from the bank and purchases a house in Darwin and makes the minimum monthly payment of $1,650. After two years the balance on Bill’s home loan is $186,000.
Bill receives a $50,000 windfall and decides to pay this money off his home loan. This reduces the balance to $136,000. He is then offered a job in Perth and decides to take the job and relocate his family, rent out the house in Darwin and borrow to purchase a new residential property in Perth. Bill redraws $50,000 from the Darwin loan and uses this as a deposit for the new home in Perth.
He can deduct the interest accrued on the outstanding loan principal of $136,000 that is related to the Darwin house from the date that property is available for rental. Bill uses the borrowed funds for income-producing purposes. However, the new borrowing of $50,000 as a deposit on the residence in Perth is incurred for a non-income producing purpose and hence not deductible.
Also, see TR 95/25 Interest deductions under ITAA 1997 s 8-1 following FC of T v Roberts; FC of T v Smith and TR 93/6 Loan account offset arrangements.
Summary
So TR 2000/2 and TR 93/6 are your backup when you want to tax deduct your home loan. Specifically Example 2 in para 61. There the ATO confirms that you can tax deduct the interest on a home loan you originally took out for a main residence. So you can repurpose a home loan.
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 17 November 2021
Tax Talks spoke to Andrew Henshaw - Director at Velocity Legal - for more details.
