Loan Interest Deductibility

Question

My wife and I own a house in Tasmania. It was purchased for $500,000 7+ years ago. We did not have any mortgage on it. We moved to Victoria 1 year ago for my wife’s work. We rented our Tasmanian house out. It was probably valued at about $480,000 then (1 year ago).

We rented in Victoria until we purchased 3 months ago. We bought a house for $530,000 and obtained a loan for $560,000 with both properties mortgaged against the loan.

We believe that we should be able to claim an interest deduction against our rental income. Can you advise please?

Answer


Such a common problem. There is certainly no way you can claim the interest on the loan to buy your house in Victoria against the rent you receive in Tasmania. Interest is only tax deductible if there is a direct nexus between the borrowed money and income producing activities, it is all about what the money is used to buy. The fact that you borrowed so you could retain a house to rent does not wash as a direct nexus.
In these circumstances it usually works out better to sell the original house. That is a lot of non deductible interest you will be paying on your new house. If you do the numbers and work out how much it is costing you in interest then reduce this by the amount of rent you will receive less expenses and income tax. Do you think the Tasmania property is going to go up in value each year by more than this? Usually the answer is no. If the answer is no, then it does not make sound investment sense to keep the property.
If you really want to keep the Tasmanian property you might consider the stamp duty costs of changing the ownership with the new owner borrowing to buy so you have cash to pay down your current debt. Examples of this would be one spouse selling their half to the other, this would only free up half the value. Alternatively set up a trust to buy the property off you. Careful you will need a unit trust if you want to negatively gear. Now the trouble with both these ideas is there appears to be no reason to do this other than the tax benefit. If this is the case the ATO can use Part IVA to disallow you a deduction for the interest anyway. If you go down this path get a ruling from the ATO first (before you pay all that money in stamp duty) as to whether they would apply Part IVA. In ID 2001/79 http://law.ato.gov.au/atolaw/view.htm?docid=AID/AID200179/00001 the ATO accepted this strategy but no mention of Part IVA. Certainly refer to this in your ruling. I have seen a few successful rulings in this regard when spouses disagree whether to keep or sell so to settle the dispute the keeper buys out the half share of the spouse who wants to sell.

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