Ask a tax advisor on the topic of Rental / Leasing

Recognition of penalty interest and prepayment penalties at the tax office

October 25, 2013 | 40,00 EUR | answered by Michael Herrmann

I have the following situation:
In 2001, my father purchased an apartment (Apt.1) without taking out a loan. Initially, this apartment was used as a condominium. In 2007, this apartment was mortgaged to purchase another apartment (Apt.2), a loan was taken out. The plan was to rent out Apt. 2. Due to the progressing cancer diagnosis and the more favorable location of Apt. 2 (opposite the hospital), Apt. 1 was ultimately rented out, while Apt. 2 was used as a condominium. In essence, a loan was indirectly taken out for the rental of an apartment, but only indirectly. The value of the apartments is roughly identical, meaning that the rent received for Apt. 1 corresponds to the theoretically achievable rent for Apt. 2.
In 2011, my father passed away, and my sister and I inherited Apt. 1+2, with a usufruct on Apt. 2. Apt. 1 continues to be rented out. The existing loan agreement was terminated by us with payment of prepayment penalties, and a new loan was taken out.
The tax office now refuses to recognize our father's interest payments and ours, as they cannot see a connection between the loan taken out and the rental. This probably also applies to the prepayment penalties.
In reality, we did repay the old loan before maturity and took out a new one in order to continue renting out the property (rental income now roughly matches the loan repayment installment).
We are aware that interest payments can only be deducted as advertising costs if they are related to income generation (§ 9 EStG).
Are there any convincing wording suggestions for our case that we can submit to the tax office (firstly: regarding the father's move into the originally intended for rental apartment; secondly: our new loan/payment of prepayment penalties was only done to maintain the rental)? Thank you very much in advance!

Michael Herrmann

Dear inquirer,

First of all, thank you for your inquiry, which I would like to answer based on the information provided and in the context of your commitment within an initial consultation. The response is based on the description of the situation. Missing or incorrect information about the actual circumstances can affect the legal outcome.

Interest on debts is only deductible as advertising expenses if they serve the acquisition, security, and maintenance of taxable income. Applied to rental income, this means that the financing must directly serve the acquisition of the rented apartment in order to be deductible. However, this is not the case here, as the financed apartment was not rented out.

All subsequent loans and mortgages cannot establish this connection anymore, as they were causally used to finance private living space and only took place chronologically after the acquisition of the rented apartment.

In principle, you can determine which loan serves the rental. However, this allocation is only possible if the funds received as a loan are actually used to pay for the expenses incurred for the acquisition or construction of that one apartment.

Unfortunately, there can be no wording assistance to use the other circumstances described as arguments. The only way to claim future interest would be to move into the previously rented apartment and rent out the financed one. The fundamental problem is that you cannot reallocate funds taken out after the acquisition.

I hope that this information has provided you with sufficient insight into the situation within the scope of your commitment and this initial consultation.

Kind regards,

Michael Herrmann
Dipl.-Finanzwirt (FH)
Tax consultant