The cost of a rental property such as a house would be a capital expense.

However the cost of interest paid on a loan to purchase that house would be 'incurred in gaining or producing assessable income'

If the cost of the rental property is financed through loan funds, rather than the purchasers own funds, then the interest payments will represent a considerable expense, and may even exceed the rental income produced.

In such a case the rental payments will be included in assessable income, and all the interest payments will be allowed as a deduction, giving rise to a net loss

Another test will be applied if the objective facts do not provide a commercial explanation for the incurring of the expense. For example, if a husband borrows funds at an interest rate of 10% and on lends them to his wife at 1%.

If there is no relevant assessable income or if the relevant income is less than the outgoing, then the objective facts do not provide a commercial explanation for incurring the expense. This is obviously relevant in the case of a negatively geared purchase of a property, which is rented out to produce income.

In such a case, there should be a commonsense or practical weighing of all the circumstances, including the direct and indirect objectives and advantages, to determine whether, objectively, the funds are used in producing assessable income.

If, after weighing up all the circumstances, it can be concluded that the funds are genuinely used in an income producing activity, a deduction may be allowed for the interest.

In the case of interest on negatively geared loans used to purchased rental properties, it seems that the Commissioner of Taxation has accepted that the outgoing is incurred in assessable income which the outgoing would reasonably be expected to produce (at some future time). In other words, the assumption will be that the taxpayer will continue renting out the property after the loan has been paid off, and the property will produce a positive net income.

If, on the other hand, it is concluded that the borrowed funds are being used in the independent pursuit of some other objective (eg exempt income) then the interest must be apportioned between the pursuit of assessable income and the other objective.

For example, if a husband

he will allowed a deduction in respect of the interest payments he makes

on his 10% loan, up to the amount of the interest he receives from his wife.

outgoings incurred in gaining or producing assessable income is equal to the amount of interest he has actually received.

The rest of the interest payments he makes on his 10% interest loan will not have this character and thus will not be allowable as a deduction.

Some time ago the Commissioner of Taxation persuaded the Government to legislate to ensure that rental losses could only be offset against rental income.

The legislation was introduced on 17/7/85 and repealed shortly thereafter, purportedly because the house rental market was contracting. No mention has since been made of resurrecting the legislation. But no one has yet devised a 100% reliable chrystal ball.

Perhaps the safest test to apply is,

'Could I afford the repayments if I was not allowed a tax deduction?'

Yet another danger of negative gearing is the possibility that interest rates may rise higher and faster than you contemplated they would when you undertook the investment, making it difficult or maybe even impossible to meet the repayments. You only have to think about the fate of the more flashy entrepreneurs of the eighties to realise that a negatively geared investment contains a certain degree of risk. Once again, if you can find a reliable chrystal ball, you can probably make more money from publishing an investors news letter than from any property investments.

IN SUMMARY...

It is firmly settled that the relevant assessable income does not have to be produced in the same year of income in which the expenditure is incurred. To quote the Master Tax Guide (para 31 170)...

The courts have held that provided that:

The decision of the High court in the last mentioned case suggested that statements to the effect that it is sufficient for the purposes of sec 8-5 that the production of assessable income is the 'occasion' of an outgoing or that the outgoing is a 'cost of a step taken in the process of gaining or producing income' are to be understood as referring to a genuine and not colourable relationship between the whole of the expenditure and production of such income.

Care should be taken to ensure that the loan is used to finance the purchase of an income producing asset. Interest on a loan to purchase a family home, will generally not be allowable.

'the laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and income derived by him from it's use'.

If the interest was payable in respect of loan monies which were not laid out for the purpose of gaining income, in other words, for the provision of a private residence for the taxpayer, then that required connection would not exist.

It would get less clear if the loan monies were being used

The Commissioner has stated that in line with a Federal Court decision he will accept that a deduction can be allowed for interest in cases where an asset has been purchased for private as well as business use.

For example, where a single asset can be depicted as having income producing and non income producing aspects, the Commissioner may be persuaded to allow a deduction for that part of the interest that relates solely to the 'notional' part of the asset

acquired for business purposes. (ITR 2661).

Of course, the mere mortgaging of an income producing property as security for a non income producing loan would not affect the character of the interest paid on that income producing property.