Finance and Interest Deductibility
One of the most common questions I am asked by clients is about deductibility of interest on loans to purchase a new residence, at which time the old residence is converted to a rental investment property.
A little known, but well established taxation principle is the ‘purpose test’. Where a loan is taken out for two purposes, one income producing and one non-income producing, an apportionment of the interest is made between deductible and non-deductible.
It is quite common for clients to upgrade their residences. Some clients, for different reasons, wish to hold their old residence, convert it to a rental property, use it as security for the new residence and claim the interest as a tax deduction against the rental income. I know that their intended purpose is to generate income from the old property. But I’m afraid the unchanging answer to this scenario is NOT DEDUCTIBLE.
In this scenario, although the purpose of the finance is to acquire a new property, the purpose of that property is for “private use”, not to produce income. The ‘purpose test’ dictates the interest is not deductible.
The next question is always: “How can I alter the purpose?” Again, the answer is they can’t. There are three options:
- Sell the property, buy a new residence, and purchase another property for investment purposes.
- If the property is held jointly, one owner can purchase the other’s share. This will only partially solve the problem as finance has been used to acquire only a portion of the property, usually half.
- Interpose another entity (eg. Family company of trust) to acquire the property. The problem with this option is the interposed entity must have other income to absorb negative gearing losses, and this is rarely an option for mum and dad property investors. If the negative gearing losses can not be absorbed then the loss has little current benefit.
Note that an interposed entity cannot be a Superannuation Fund. At date of writing, while “commercial” property can be transferred to a Superannuation Fund, an in-specie transfer of residential property is not presently permissible.
Post by Guest Writer David Maynard – CEO of My Tax Zone
Filed Under: Property Investment • Tax Tips
About the Author: 
