When a rental property is sold, the sale proceeds may not always be sufficient to fully repay the outstanding balance of any loan used to acquire the original investment. The issue raised in these circumstances are whether (and for how long) deductions can continue to be claimed for interest expenses incurred after the sale of the asset (i.e., ‘post-cessation interest expenses’), when no income continues to be derived in respect of the asset.
Fortunately, it has become a generally accepted principle that such interest deductions can continue to be claimed in respect of an outstanding loan balance related to an income-earning Activity that has ceased (i.e., a former income-earning activity), provided the occasion of the interest expenses can be found in that former income-earning activity. This is the case in both a business and non-business context. Refer to paragraph 10 of TR 2004/4.
That is, under the occasion test, where the occasion for an outgoing (e.g., interest expenses) originates from a transaction (e.g., a loan agreement) entered into in carrying on a former income-earning activity, a deduction (e.g., for interest expenses incurred) will generally be allowed under S.8-1. Refer to FCT v Brown [1999] FCA 721, Guest v FCT [2007] FCA 193 (Guest’s case) and TR 2004/4. When applying the occasion test to post-cessation interest, the ATO has provided a number of practical guidelines (primarily in TR 2004/4) that should be considered before claiming interest expenses after the sale of a rental property and are outlined as follows.
1. Application of sale proceeds
For interest to remain deductible, the net sale proceeds from the sale of the income-earning asset (e.g., shares or a rental property) should be fully applied to the loan. Refer to TR 2004/4.
2. Legal entitlement to repay loan early
Generally, any legal entitlement to repay the loan before maturity would not, of itself, affect the deductibility of post-cessation interest expenses.
3. Capacity to repay loan
In TR 2004/4, the ATO takes the approach that a legal or economic inability to repay suggests that the loan has been kept ‘on foot’ for purposes related to a taxpayer’s former income-earning activities.
4. Re-financing
The re-financing of an existing loan after the sale of the income-earning asset (or investment) will not, of itself, break the nexus between the interest expenses and the former income-earning activity.
5. Length of time
In TR 2004/4, the ATO makes the comment that the: “…greater the time since the cessation of the income earning activities, the more likely it is that an inference could be drawn that the continuing obligation to pay interest is as a result of the taxpayer choosing to keep the loan on foot for reasons unassociated with the former income earning activities.”
As a result of these generally accepted principles, a common question that has been raised following the introduction of S.26-102 (and the restriction it places on the deductibility of holding costs in relation to vacant land from 1 July 2019) is how it impacts on a taxpayer’s ability to claim post-cessation interest on any resulting loan shortfall (following the disposal of a rental property).