Finance Act 2002 Rental Income

Rental Income -Deductibility of Loan Interest and Related Issues

Restoration of relief for residential premises 1 January 2002

Detailed articles on Finance Act (No.2) Act 1998 and Replacement Borrowings were contained in Tax Briefing - Issues 32 and 33, respectively. Section 1 of the Finance (No.2) Act 1998 introduced a restriction on the deductibility of interest on borrowed money used on or after 23 April 1998 in the purchase, improvement or repair of a residential premises, in arriving at the taxable rent (or allowable loss) in respect of that premises. This restriction applied to individuals, companies, trusts and partnerships.

Section 17 FA 2002 amends Sections 97 and 248A TCA 1997 so as to restore interest as a deductible expense in calculating tax on rental income (or an allowable loss) from residential property. The interest in question is interest on borrowed money employed in the purchase, improvement or repair of such property and which accrues on or after 1 January 2002. This applies to foreign residential premises in the same manner as it applies to premises in the State. The restoration of relief not only applies to individuals, but also applies to interest on borrowed money invested in, or lent to, a company or partnership to the extent that the money is used, directly or indirectly to purchase, improve or repair rented residential premises.

Queries from practitioners

We have received a number of queries from practitioners on whether interest will be available as a deduction against rental income from 1 January 2002 in relation to rented residential premises:

• Where a loan employed in the purchase, improvement or repair of rented premises is replaced by another loan
• Where existing loans are amalgamated
• Where a loan is secured on the borrower’s private residence, but the money is used to purchase a property for letting.

Previous Practice

The article in Tax Briefing Issue 33, which was written in the context of the restrictions on borrowings introduced by the Finance (No. 2) Act 1998, confirmed that Finance (No.2) Act 1998 did not affect the treatment for tax purposes of interest on replacement loans. It also confirmed Revenue’s practice to look at claims for deduction in respect of interest on replacement loans on a case-by-case basis. It outlined the circumstances in which interest on replacement loans would be allowed and provided that the existing practice of apportioning loans would be discontinued.

Current Practice

This article sets out current Revenue practice on interest on replacement or amalgamated loans in calculating rental income. Practitioners should note that the treatment of interest on residential and non-residential property, i.e. commercial property, is not the same. Commercial borrowings are looked at on a case-by-case basis, while taxpayers with residential borrowings need not seek pre-clearance provided they come within the paragraph dealing with Replacement Loans -Residential Property.

Borrowings for Residential property

Existing Borrowings

Generally, interest on an existing qualifying loan for residential property will qualify as a deduction where there is a variation of the terms of such a loan, e.g. repayment period extended. It will be a question of fact in each case as to whether the existing qualifying loan still exists or whether a new replacement loan has been taken out.

Generally, where

• There is a variation in the basis on which payments are allocated between interest and capital or
• The period of the loan is extended for genuine commercial reasons on an arm’s length basis and not for the avoidance of tax

the existing loan will be treated as continuing.

Example - extension of term of loan

John has an existing qualifying rented residential property, which has been let since 1997. He purchased this property with a 5-year mortgage carrying an interest rate of 6%. He now wishes to refinance and extend the term of the loan to 15 years. Will this affect the deductibility of the mortgage interest?

No. As long as the original loan was used for one of the purposes specified, i.e. the purchase, repair of the premises, the interest is deductible.

Replacement loan - residential property

Revenue recognise that some taxpayers wish to take out replacement loans on residential property to enable them to avail of a more beneficial interest rate or a more suitable method of repayment. The practice outlined in Tax Briefing Issue 33 of

• Requiring a replacement loan to do no more than replace the outstanding balance on the existing loan and
• The term of the replacement loan being no longer than the term of the existing loan

is being discontinued from 1 January 2002 where the existing loan is being replaced for genuine commercial reasons on an arm’s length basis and not for the avoidance of tax.

Amalgamation of loans -residential property

It would be preferable if separate loans rather than amalgamated loans were taken out where existing borrowings are refinanced and further amounts are borrowed or a number of loans are refinanced at the same time. However, in refinancing situations it is increasingly common for financial institutions to require the amalgamation of all existing loan facilities into one separate loan as part of their security requirements. In practice, interest on amalgamated borrowings which accrues on or after 1 January 2002 will qualify for relief where:

• The capital and interest in respect of the each rented residential property can be readily identified and traced back to the original borrowings and
• Borrowings were amalgamated for genuine commercial reasons on an arm’s length basis and not for the avoidance of tax.

Apportionment of borrowings between qualifying and non-qualifying purposes-residential property

In all cases the onus is on the taxpayer to make a just and reasonable apportionment of qualifying interest and non-qualifying interest especially where loans are amalgamated and there is a subsequent sale of a property. In the case where the taxpayer financed the purchase of property with amalgamated loans he/she cannot claim any further interest as a deduction in respect of the part of the amalgamated loan that referred to the property that has been sold. The fact that the borrowings were not secured on this particular property is not relevant, as it is the application of the borrowings that is relevant. The remaining qualifying interest after apportionment will be deductible.

Stamp duty and legal fees

Loans which include the additional costs of stamp duty and legal fees incurred on the purchase of a property will have to be apportioned as there in no provision in the legislation for deduction of interest

on part of the loan relating to stamp duty or legal fees. Taxpayers may claim a deduction for the interest relating to the purchase price of the property only.

Security for loan on another property

It is not necessary that the security offered should be the premises, which is let, in order that the interest is deductible. For example, where an individual obtains a loan which is secured on his/her principal private residence, which is used to defray the cost of purchase, improvement or repair of premises, which is in turn let, the interest qualifies as a deduction.

Other issue - fines on loans

The issue of interest caps/payments was considered in Tax Briefing Issue 25.The interest cap is part of the interest relating to the loan. An issue has arisen as to the correct tax treatment of a once off payment/cap fee. In such a case the payment should be spread over the term of the loan in accordance with normal accounting practice so that the payment is matched to the periods to which it relates.

Replacement Borrowings for Commercial Property

Generally, in the context of commercial borrowings it will be a question of fact in each case as to whether an existing loan still exists or whether a new replacement loan has been taken out. Borrowings on commercial property will be looked at on a case-by-case basis. Subject to this, the general position is that interest on a loan, which directly replaces an existing loan on a rented commercial property, may be allowed where:

• The replacement loan was for genuine commercial reasons
• Is not part of a scheme or arrangement the main purpose of which is the avoidance of tax.

Practitioners with queries in individual cases relating to commercial borrowings only should contact the Office of the Chief Inspector of Taxes and submit the following details:

• The full name, address and tax reference number of the parties to the transaction
• The date the original loan was acquired
• The interest rate applicable over the term of the original loan
• The amount outstanding on the original loan
• The projections regarding the payment of the original loan, if any
• The rate of interest applicable to the replacement borrowings
• The business purpose behind the replacement of borrowings and details of any prior or further steps involved.

Additional information may be required.