Only pro rata debt interest deduction in the case of an isolated pro rata gift of a leveraged rental property

Debt interest is tax-deductible as income-related expenses if it is economically related to a specific type of income (Section 9 (1) sentence 3 no. 1 of the German Income Tax Act). In the case of income from letting and leasing in particular, this applies to debt interest resulting from the financing of the property. In its rulings of December 3, 2024 (case no. IX R 2/24 and IX R 3/24 (NV)), the German Federal Fiscal Court had to decide on the tax deductibility of debt interest as income-related expenses following a pro rata, free transfer of a rental property financed by third parties.

In the case in dispute in both rulings, the sole owner of a rented property transferred a 2/5 co-ownership share to his son as a gift. The previous loans that the taxpayer had taken out to purchase the property or to finance the rental property remained with him. There was no assumption of debt or assumption under the law of obligations of the loan liabilities attributable to the transferred co-ownership share. The tax office only recognised the debt interest claimed in full for tax purposes in the year in dispute as income-related expenses in accordance with the father's co-ownership share of 3/5 of the income from letting and leasing the jointly owned property that arose after the property transfer. Both the Lower Saxony Fiscal Court and the German Federal Fiscal followed the legal opinion of the tax office.

The original economic connection between the debt interest resulting from the loan liabilities and the income from letting and leasing was broken insofar as the co-ownership share in the property rented to a third party was transferred to the son as a gift with the liabilities retained. As a result of this transaction, the retained loan liabilities lost their property-related character. The corresponding debt interest - insofar as it was attributable to the transferred co-ownership share - was therefore no longer allocated to the acquisition sphere relevant for income tax purposes, but to the private sphere of the donor. The German Federal Fiscal Court also did not consider an intended but not actually realised assumption of debt by the donee to be sufficient to establish the economic connection between debt interest and income from letting and leasing required for the deduction of income-related expenses.

In the area of profit income, the German Federal Fiscal Court ruled differently in its ruling of April 27, 2017 (case no. IV B 53/16 (NV)) on the tax deductibility of loan liabilities in a similar case. If a debt-financed property of the special business assets is transferred free of charge to the joint assets of another co-entrepreneurship at book value while retaining the loan liability, the loan liability must be recognised in full as negative special business assets at the other co-entrepreneurship. The interest paid on the loan is deductible in full as a special operating expense.

However, the German Federal Fiscal Court did not apply this view, which applies to profit income, to the present dispute involving surplus income. The recognition of interest on debt in the business and private sphere is a matter of different circumstances. There is no violation of the general principle of equal treatment insofar as interest on debt in the area of private sphere of assets as a result of the free transfer of the financed asset while retaining the loan liability with the previous owner - unlike in the business area – cannot be recognized for tax purposes.

With its rulings, the German Federal Fiscal Court reinforces the dualism of income types between surplus and profit income that applies in income tax law and is confirmed by constitutional law. While increases or decreases in value in the business sector generally affect the amount of income, such increases or decreases are only subject to taxation in the case of surplus income if they fulfil a corresponding income criterion, such as letting and leasing.

Notice:

In gift cases such as the one in dispute, the loan liabilities attributable to the transferred co-ownership share in the respective rental property must also be transferred under the law of obligations if interest on debt is to continue to be fully deducted as income-related expenses for income from letting and leasing.