TR 2000/2 explains how to apportion deposits and interest on mixed purpose loans

Question

I hope you’re well.
I’m seeking your professional advice on a tax matter regarding interest deductibility relating to client’s former principal residence, which became an investment property in 2019.

Here is a summary of the situation:

In 2019, they moved out of the primary residence (originally built for around $300,000) and converted it to an income-producing rental property.
At the time of conversion, still had mortgage which has continued being paid with only around $5,000 remaining on the original loan.
Since then, the property has been used solely as a rental and has generated assessable income.
In a separate transaction, they took out a $400,000 mortgage to purchase a new personal residence, which they currently live in.
They are now considering refinancing the investment property, possibly drawing equity from it or combining loans etc.

I understand that the ATO generally bases interest deductibility on the use of borrowed funds, not the security of the loan. However, I am exploring whether there is any legal or strategic way that refinancing the investment property (which now has substantial equity) could allow the resulting interest payments to be deductible – either in full or in part.

Would you please advise:

Whether any portion of the interest on a new or refinanced loan against the investment property could be deductible in this case;
If there are any structuring options or financial instruments that could enable deductibility under current ATO rules;
If a debt recycling or trust structure could potentially be applied here; and
Any compliance or documentation considerations I should keep in mind if pursuing this route.

Much Appreciated

Answer

That is right the deductibility of the interest is determined by what the borrowed money was used to buy not where it is secured. In the case of refinance you look to the purpose of the original borrowings.

I have attached our apportionment calculator that you can use if they end up combining the loans. It apportions any deposits and interest in accordance with TR 2000/2

https://www.ato.gov.au/law/view/document?docid=TXR/TR20002/NAT/ATO/00001

In particular

16. Where interest accrues daily under a mixed purpose sub-account, a taxpayer is entitled to a deduction in respect of that part of the interest that has accrued on the portion of the outstanding daily loan balance attributable to an income producing purpose. In calculating the portion of the outstanding daily loan balance attributable to an income producing purpose, any repayment of principal is applied proportionately against the outstanding balance of amounts applied to income producing and non-income producing purposes respectively, at the time the repayment is made

Have a bit of a play around with the apportionment calculator and see what happens, over time, when you use this mixed purpose loan account to say put all the rent into it and pay the rental expenses out of it, if that is possible. The ruling says the rent deposits must be apportioned between the deductible and non deductible balance on a pro rata basis but the withdrawals must be allocated according to their purpose. Of course you can’t do this as a scheme with the dominant purposes of increasing your tax deductible debt (part IVA) but what are you going to do?? You need to follow the instructions in the ruling and it makes sense to pay the rental expenses out of the account where the rent is paid into and it makes sense to appropriate the rent towards the loan, taking every opportunity to reduce the interest asap.

To your questions:

Would you please advise:

Whether any portion of the interest on a new or refinanced loan against the investment property could be deductible in this case;
- Yes as discussed in TR 2000/2 it is just about the purpose the original borrowed funds were put to as long as the nexus is not broken the portion of the new loan that relates to the deductible loan will have the interest on it tax deductible.
If there are any structuring options or financial instruments that could enable deductibility under current ATO rules;
- Any actual products in this regard would be caught as a scheme with the dominant purpose of a tax benefit by increasing the deductible debt artificially.
If a debt recycling or trust structure could potentially be applied here; and
- The house could be sold to a trust or other entity but that is a lot of stamp duty and possibly capital gains so probably not worth it. And even then you still have the question of whether the dominant purpose was a tax benefit.
Any compliance or documentation considerations I should keep in mind if pursuing this route.
- Always be very careful not to lose the nexus, no detours of borrowed funds on their way to pay out the deductible loan.

TR 2000/2 explains how to apportion deposits and interest on mixed purpose loans

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