Asset Substitution and Investment Loans

Question

Hi Julia,

I am currently living in my owner occupied home and I have several split loans against it which were used as a 20% deposit to purchase an investment
property and 2 more splits to fund the construction of an investment property. I claim tax deductions on these splits as the purpose of these loans are for investment purpose.

My situation is that we want to purchase another owner occupied property for us to live in and move into that property immediately
upon settlement. If we sell our current residential home and do a back-to-back settlement then we can do a so called asset substitution
and the investment loan splits would now be secured against another asset (our new primary residence). The new house is more expensive
and we will need to top up using my own funds or using the equity from another home.

I have been advised by a financed broker that the investment split loans will not be tax deductable as the purpose of the loans would be deemed to have changed to
purchase/acquire a (non tax deductable) new primary residence. However, my tax accountant argues that the purpose of the loans has not really changed as they are
still supporting the investment properties that are still producing income but the top up amount will not be tax-deductible.

Who is right and how can I make sure that the split loans remain tax deductable?

Cheers,
Peter

Answer


Your accountant is right of course, finance brokers should not give tax advice. Was the objective to persuade you to setup new loans?
TR 2000/2 http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR20002/NAT/ATO/00001 states:
29. The character of interest is determined by the purpose of the borrowing. Generally, the purpose of a borrowing can be determined from the use of borrowed funds and outgoings of interest ordinarily draw their character from that use (see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613). It is recognised that it may be appropriate to distinguish between the purpose of the taxpayer in borrowing the money and the use to which the borrowed funds are put in an appropriate case (see Steele v. DC of T 99 ATC 4242, at 4251; (1999) 41 ATR 139, at 150).
30. The term ‘use’ in this context does not necessarily require a strict tracing approach to the application of the borrowed money (see FC of T v. JD Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494). Rather, the characterisation of interest on borrowed money (and the purpose of the borrowing) is ascertained by reference to the advantages sought from the use of the borrowed funds. In Kidston Goldmines Ltd v. FC of T 91 ATC 4538 at 4545-6; (1991) 22 ATR 168 at 176-7, Hill J. stated:
‘In most cases, the purpose of the borrowing will be ascertained from the use to which the borrowed funds were put…
To be deductible the outgoing, or in a case of apportionment a part of an indivisible outgoing, must be seen to be incidental and relevant to the activity which is directed to the gaining or production of assessable income. In the normal case, the fact that funds borrowed have been borrowed for the purpose of that activity and can still, in the year of income in which the deduction is claimed, be seen as having that purpose, will lead readily to the conclusion that the interest will be incidental and relevant to the income producing activity. Again, in the usual case the application of funds for an income producing purpose will demonstrate the relevant connection between the outgoing and the income producing activity. Indeed there is much to be said for the view that the tests of purpose and application of funds are but two sides of the one matter.’
It is all about what the borrowed money was used for not where the loan is secured. But what you have to be very careful about is that the banks don’t on the sale of your old house pay out the loans then redraw funds to pay for your new home. Even if they did this by accident or for just a minute the ATO would consider the deductible debt to be fully repaid and then test what the redraw was for and of course that would be for private use. Its all about cash flowing in and out of the accounts.
Make sure the top up is in a separate loan of course.

. .
Have a question about tax you need answered?

. Ask your own tax question here for only $79.95