With the decline in the value of shares and properties alike, quite often we are faced with a situation where a client may have excess loan(s) left over after selling their shares or property.
The issue then becomes is the interest still being paid able to be claimed as a tax deduction even after the income-producing asset has been sold.
In order for interest to be deductible, the taxpayer must establish that the essential character of the interest incurred was to gain assessable income. In determining the character of the interest, regard must be had to its connection with the income-producing activities of the taxpayer. The primary test for deductibility of interest is determined by examining the purpose of the loan and use to which the loan is put to.
As a general rule, interest on money borrowed to acquire an income-producing asset will be deductible where it is reasonably expected that assessable income will be derived from the investment. Interest will not be deductible where the income-producing asset is acquired solely for the purpose of making a capital profit on their resale and the proceeds on sale are not assessable as ordinary income.
While the interest on the loan for the income-producing asset will be deductible, it needs to be determined whether the sale of the asset would change this position. The Tax Office has considered how the cessation of an income-earning activity, such as a sale of income-producing asset for which the money was originally borrowed, affects the deductibility of the interest paid on the loan.
When borrowed money has been used to purchase an income-producing asset and that asset is subsequently sold, the original use of that money will not necessarily determine the character of the interest expense paid on those borrowed funds.
The Tax Office in Taxation Ruling TR 2004/4 accepts that interest incurred after the sale of an income-producing asset may be deductible. Where interest has been incurred after the asset representing the borrowings has been sold, the outgoing will still have been incurred in gaining or producing assessable income if the outgoing was producing assessable income of an earlier period.
This is a question of the connection between the outgoing and income-earning activities. The Tax Office says that interest will not fail to be deductible merely because:
- the loan is not for a fixed term;
- the taxpayer has a legal entitlement to repay before maturity, that principal with or without penalty; or
- the original loan is refinanced whether once or more than once.
The connection will be broken 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 income in connection with which the debt was originally incurred.
The Tax Office considers a legal or economic inability to repay suggests that the loan was not kept on foot for purposes other than the former income-earning activities.
Therefore, provided the income-producing asset was productive of assessable income of an earlier period, the debt remains payable due to an inability to repay, and the loan has not been kept on foot for other reasons, the interest on the shortfall under the original loan should remain deductible.
If you have any questions regarding how these rules may apply to your situation, please contact Ellingsen Partners.