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If I Lived In A House Before Renting It Out, Is My Mortgage Interest Tax Deductible?

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Contributor:
Mary Holm
Mary Holm

Question:

Due to change in circumstances I've decided to rent my home.  The house has a mortage and I've heard mixed messages on whether the interest on that loan will be tax deductible when I rent out the property.

What's your understanding?

Answer:

Mary Holm: Inland Revenue say:

"Whether or not mortgage interest is tax-deductible when renting out a family home depends very much on the circumstances of the rental situation.

"In some circumstances, if the owner of a family home decides to move out of that home and rent the house out to a third party, mortgage interest can be deductible as a rental expense, and the owner does not need to transfer the home into another entity in order to claim mortgage interest deductions.

"Case law has determined that the interest can be deductible when it is connected to an income-earning process. The courts have said that it is relevant to consider the use of the borrowed funds.

"The Court of Appeal said in the Banks case in 1978 that the test is to examine how the capital was employed during the period when the interest claimed as a deduction was incurred, not how the capital was employed when first borrowed.

"This means that the test for interest deductibility is to consider whether there is a sufficient link between the interest being deducted and the use of the borrowed funds. From the point in time when the taxpayer uses the house to derive rent, the borrowed funds are used to finance the rental property and the interest is deductible from that point.

"If there is some uncertainty as to whether rent was in fact being paid, or over the use of the property, then the taxpayer would have to clearly demonstrate that there had been a fundamental change from a private to an income-earning use.

"The fact that the mortgage was initially taken out on the family home does not alter the fact that the interest on the mortgage can be tax-deductible, so long as it has been taken out expressly to buy the home, and does not contain later borrowings (or top-ups) for other purposes.

"Circumstances can differ in various cases. For example, there is the situation in which a person may own a family home freehold and then borrows and uses the borrowed funds to buy a second property. The loan is secured over the first property.

"The taxpayer moves into the second home and rents out the family home. In this case, the taxpayer cannot claim the interest on the mortgage incurred on the family home as tax-deductible. The interest on the borrowed money is not deductible as it is not connected to an income-earning process. The fact that the loan was secured over the first property which is now earning income does not make a difference.

"Individual circumstances can vary, and we suggest that anyone who has queries about their own situation either contacts a tax adviser or calls the department."

To which I add, "Amen", and an apology to correspondents and readers who were confused by the material in the earlier columns.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.    

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