ATO to reject capitalisation of interest on investment property loans?

Does anyone really believe that the main reason underpinning a decision to negative gear is something other than tax minimisation? Or to claim a tax deduction for property management expenses? Or to claim a deduction for your contributions to charity?

There's nothing wrong with tax minimisation. Why pay more tax than you are required to?

Tax minimisation is allowed. Tax avoidance is not.

The question here is whether the ATO views the arrangement in question as minimisation or avoidance. At the end of the day, the ATO and government simply make decisions about whether or not they allow certain arrangements. If they say yes, then it's tax minimisation. It they say no, then it's tax avoidance.

While that's a perfectly sound argument, I don't think it gets past TF's question.

If the courts have to decide what is minimisation and what is avoidance, then the courts might well reach the conclusion TF implies.

By my reading (and I could be wrong, I admit), capitalising interest as we are discussing here is entirely contrary to the spirit of the Tax Act.

So, while I well know we all regard tax law as black letter law (i.e. if there be a spirit, it can stuff off and bother someone else), the courts can and do sometimes look to the spirit of the Tax Act, and then can interpret with retrospective intent.

Call me a fool, but this is why I personally stay out of the grey and don't capitalise interest.
 
If the courts have to decide what is minimisation and what is avoidance, then the courts might well reach the conclusion TF implies

They courts might agree or disagree with the ATO. I read somewhere that the ATO actually loses most of its court battles. The problem is that small fry investors like you and me normally don't have the time, energy or funds to take on the ATO in court, so the ATO relies on most people like us just giving in. For the sake of $5K or whatever, I couldn't be bothered fighting it in court. I'd just pay up.
 
Kudos Shadow. It is all a bullying match - under the tax law you are presumed to be guilty unless proven otherwise through an (expensive) court of law.
 
They courts might agree or disagree with the ATO. I read somewhere that the ATO actually loses most of its court battles. The problem is that small fry investors like you and me normally don't have the time, energy or funds to take on the ATO in court, so the ATO relies on most people like us just giving in. For the sake of $5K or whatever, I couldn't be bothered fighting it in court. I'd just pay up.

While this may well be the case, the issue of ATO bullying (currently quite a public one) is taking this discussion off topic.

Has anyone offered a philosophically coherent explanation for why capitalising interest (while paying off a PPOR with PI income) is not contrary to the essential logic (or 'spirit') of our Tax Act?

That is, while I know that the discussion today revolves around finding instances that could 'reasonably' slip through the tax net on technicality grounds, the core issue of principle is always where the courts ultimately end up (again, I tentatively submit).
 
Originally Posted by Shadow View Post
Tax minimisation is allowed. Tax avoidance is not.
Same thing, both legal, just different words.

You're thinking of Tax Evasion, which is illegal.

Tax minimisation is fine. Tax avoidance = tax evasion.

http://www.ato.gov.au/atp/content.aspx?menuid=0&doc=/content/00244038.htm&page=2&H2

Tax minimisation or tax avoidance?

Tax minimisation is when your tax affairs are arranged in a way that complies with the law to reduce the amount of tax you pay.

A tax avoidance scheme is an arrangement where the intention is to avoid or defer tax obligations.
 
I really don't understand why the ATO thinks it is unfair to capitalise interest on IP loans while using the income produced by the IP for private purposes. The income produced by the IP is counted towards the taxable income, hence is taxed, so why does ATO think it is unfair to use those already taxed income for any private purpose including paying off other private loans?

Suppose I run a business. Does ATO say I am not allowed to borrow money to pay for business expenses (interest tax deductible) while taking out profits, paying tax on it and using the after-tax income on private purposes?
 
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Governments impose taxes upon taxes.

What's wrong then with a taxpayer claiming interest upon interest?

This screams double standards to me....
 
I really don't understand why the ATO thinks it is unfair to capitalise interest on IP loans while using the income produced by the IP for private purposes. The income produced by the IP is counted towards the taxable income, hence is taxed, so why does ATO think it is unfair to use those already taxed income for any private purpose including paying off other private loans?

Hmm don't forget that the IP income is not taxed until you do your tax return so until then it's basically tax-free money.
 
I really don't understand why the ATO thinks it is unfair to capitalise interest on IP loans while using the income produced by the IP for private purposes. The income produced by the IP is counted towards the taxable income, hence is taxed, so why does ATO think it is unfair to use those already taxed income for any private purpose including paying off other private loans?

It's because the expenses related to that income are deductible against your income.

You are confusing income with profit. You can do whatever you want with after tax profit.
 
Hmm don't forget that the IP income is not taxed until you do your tax return so until then it's basically tax-free money.

Hi Aaron,

I see your point; but on the same token, IP expenses are not deducted until the tax return is done as well; so the ATO gets a bigger benefit there when IP's are negatively geared.

In any event, I don't see why ATO thinks using rental income to pay for private loans is "tax evasion". Surely, the rental income is taxable and is taxed. So, where is the evasion?

If there is any tax evasion, it occurs when we take out rental income for private use while capitalising the interest. However, ATO does not say that taking out rental income for private use while capitalising the interest is "tax avoidance" per se. This is allowed. This is where the problem is.

After the rental is taken out, and used for private purpose; the purpose does not result in more or less tax payable. Whether we deposit the rental income in to the PPOR mortgage or whether we go on a holiday with it or whether we spend it to meet our daily expenses, it does not increase or decrease the tax we pay. That is why I can't understand how paying off the mortgage is tax evasion.


I don't see any logic in saying, "No, you can't use that money to pay for a mortgage, but you can use it to buy a car or to go on a holiday". Moreover, one can always say that the exact dollar notes one received from the rent was used to pay for one's credit card bill, car maintenance etc (which means his other usual income goes towards paying off the home mortgage).
 
It's because the expenses related to that income are deductible against your income.

You are confusing income with profit. You can do whatever you want with after tax profit.

Dan,

IP Expenses are tax deductible.
IP Income is taxable.

Suppose my taxable salary is $80,000.
IP Expenses: $20,000
IP Income: $15,000


So, I have to pay tax on the amount of: $80,000 + $15,000 - $20,000

What this shows is that the rental income of $15,000 is taxable and is taxed.

If I had not received the rent, my taxable income would have been only $80,000 - $20,000. Now that I have received a nice $15,000 in rental income, it is counted towards my taxable income and is taxed.
 
Dan,

IP Expenses are tax deductible.
IP Income is taxable.

Suppose my taxable salary is $80,000.
IP Expenses: $20,000
IP Income: $15,000


So, I have to pay tax on the amount of: $80,000 + $15,000 - $20,000

What this shows is that the rental income of $15,000 is taxable and is taxed.

If I had not received the rent, my taxable income would have been only $80,000 - $20,000. Now that I have received a nice $15,000 in rental income, it is counted towards my taxable income and is taxed.

No, the income and expenses from a property are related. The outcome from your example is a tax deduction of $5000, not income oif $15,000 and deductions of $20,000.

But that's not the point. The question relates to interest deductibilty, which is determined by the underlying use of the loan.

If you borrow $400,000 to buy an income producing property, yes, you can claim the interest.

If that loan goes to $450,000 because you made a choice to capitlaise interest and pay down other non-deductible debt, what is the underlying use of that $50,000? It's not to buy an income producing asset. It's to pay down non-deductible debt, isn't it?

I don't think you should be able to claim the interest on the $50,000, because I don't think it meets the interest deductibility test (in this example)

See Hart's case.
 
After the rental is taken out, and used for private purpose; the purpose does not result in more or less tax payable. Whether we deposit the rental income in to the PPOR mortgage or whether we go on a holiday with it or whether we spend it to meet our daily expenses, it does not increase or decrease the tax we pay. That is why I can't understand how paying off the mortgage is tax evasion.

It does decrease tax. The IP interest is increasing, because the loan is increasing. This is because of the choice to capitalise interest, and use the income to pay down non-deductible debt.

Higher expenses means lower total income, means lower tax collect.
 
If you borrow $400,000 to buy an income producing property, yes, you can claim the interest.

If that loan goes to $450,000 because you made a choice to capitlaise interest and pay down other non-deductible debt, what is the underlying use of that $50,000? It's not to buy an income producing asset.

We don't refinance up to 450,000 and withdraw the extra 50K. If we did that, interest on that 50K would not be deductible.

However, what happens here is different thing. We use rental income for a private purpose while capitalising the interest. ATO does not out rightly ban this. Then the question is, why it becomes "tax evasion" when the rental income is used to pay off a PPOR mortgage? If the rental income was used for any other private purpose like meeting 'living expenses', why is that ok?
 
It does decrease tax. The IP interest is increasing, because the loan is increasing. This is because of the choice to capitalise interest, and use the income to pay down non-deductible debt.

You are right except for "...and use the income to pay down non-deductible debt.". What decreases the tax payable is the fact that you are allowed to take out rental income and spend on a private purpose. The purpose the rental income is used does not increase or decrease the tax payable as long the purpose is a non tax-deductible private purpose.

What I mean is, the private purpose, on which the rental income is spent does not increase/decrease the tax.

Eg 1 - Rental income is used to pay for PPOR mortgage
Eg 2 - Rental income is used to pay for living expenses
Eg 3 - Rental income is used to pay for holidays

If any of the above is in place while the IP interest is capitalised, the tax payable is the same for all three cases. So, why is only Eg 1 is called "tax evasion"?
 
Suppose my taxable salary is $80,000.
IP Expenses: $20,000
IP Income: $15,000


So, I have to pay tax on the amount of: $80,000 + $15,000 - $20,000

What this shows is that the rental income of $15,000 is taxable and is taxed.

If I had not received the rent, my taxable income would have been only $80,000 - $20,000. Now that I have received a nice $15,000 in rental income, it is counted towards my taxable income and is taxed.

No, the income and expenses from a property are related. The outcome from your example is a tax deduction of $5000, not income oif $15,000 and deductions of $20,000.

I think you are a little confused here.

ATO cannot say an IP has to produce an on going income. As far as I have understood, you can buy an IP, not rent it and sell it after x years if you believe that will still give you a profit. IP does not need to be a house. You can buy diamonds or antiques that produce no ongoing income, for example.

So, if you invest $500K on an IP (house).
Suppose your tenants were defaulters and do not pay you rent.
You have $20,000 a year expenses for IP.

So, your taxable income is: $80K (your salary from other sources) - $20K.
So, you end up paying tax on $60K.

Now, say, your tenants decide to pay back the rent. So, you'll get a nice $15K. Then, your taxable income jumps up by $15K, which means you end up paying tax on the $15K. Suppose your marginal tax rate is 30%. So, when the tenants finally decided to pay you $15K, ATO takes 30% tax out of $15K and only gives you $10,500. That is why I say that we pay tax on the rental income. Once we pay the tax, I don't see any reason why ATO can still say, "Sure you paid tax on that money, but I don't like you spending it for purpose X".
 
What I mean is, the private purpose, on which the rental income is spent does not increase/decrease the tax.

Eg 1 - Rental income is used to pay for PPOR mortgage
Eg 2 - Rental income is used to pay for living expenses
Eg 3 - Rental income is used to pay for holidays

If any of the above is in place while the IP interest is capitalised, the tax payable is the same for all three cases. So, why is only Eg 1 is called "tax evasion"?

Aah OK, now I get where you are coming from.

Good question. I don't have an answer, other than that I think down the track, any capitalisation of interest for private purposes will be looked at under Part IVA
 
I think you are a little confused here.


Now, say, your tenants decide to pay back the rent. So, you'll get a nice $15K. Then, your taxable income jumps up by $15K, which means you end up paying tax on the $15K. Suppose your marginal tax rate is 30%. So, when the tenants finally decided to pay you $15K, ATO takes 30% tax out of $15K and only gives you $10,500. That is why I say that we pay tax on the rental income. Once we pay the tax, I don't see any reason why ATO can still say, "Sure you paid tax on that money, but I don't like you spending it for purpose X".

No, I'm not confused at all.

Let's say you only have investment properties and no other income. You have $100,000 in income, and $120,000 in expenses. How much tax have you paid on that income?

Zero. Why? Because the expenses offset all the income, and you have returned a net loss for the year.

The tax you are paying in your example is not on the rental income, it's effectively on your other income. The rental property has produced a net loss, and no income tax is payable.

Without the rental property, you pay tax on $80k. With the property, you pay tax on $75k.

In the end it doesn't matter, because you pay tax on your all up income anyway.

Anyway, the ATO's issue is not what you spend the money on, it's the capitalising of interest. Your focusing on the income side, when it's the increase in deductions (and therefore tax) that the ATO have an issue with.
 
Yes but the test is whether there is a 'scheme' in place. It is hard to argue that paying your private living expenses or holiday is a 'scheme' to minimise tax.
 
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