Capitalising interest - draft ruling

[Corsa]

Previously, I was of the opinion that capitalising interest was deductible as long as the purpose was not tax avoidance. So, all a taxpayer had to do was prove that the purpose was not tax avoidance. The taxpayer did not have to prove that the purpose of capitalising the interest was related directly to that income producing asset.

Sorry Poppy, this is incorrect. A tax payer in all instances, regardless of capilising interest expenses or any other tax expenses must demonstrate the relationship to producing income and must not be avoiding tax.

In my case, I have no non-deductible debt and only sometimes capitalise interest when I have limited cash flow, and make principal repayments when I can. So I was confident that the capitalised interest was deductible as I am clearly not trying to avoid tax in this situation.

Poppy, the fact that you have no non-deductible debt has no bearing on the relationship as to whether an expense is deductible or not. The tax office requires that an expense incurred in relation to income earning is deductible. If it is used for personal or domestic it is not.

So if your interest capitalisation is used to fund investments then it is deductible. If it is used to fund you personal situation when you have limited cash flow it is not deductible.

In this instance you would be better off using rents to fund your personal and using capilised interest to fund your investments.

According to this TD, it seems that it is NOT ok if, for example, your spouse is having a baby/sick etc and you need to pay for household expenses so you capitalise your IP repayments.

This is not my reading of the Tax ruling.

Further according to this article it would seem that even if, in general, a taxpayer made both principal and interest repayments on an IP loan, but on one occasion was unable to make the repayment and capitalised the interest... they would end up with a contaminated loan.

Not clear on why this would be the case.

 

[Corsa]

So, is it legal to capatilize interest on a IO loan and use the rent recieved for living expenses?

Yes. The reason being is you are capilising interest to fund an income earning asset.

 

[Corsa]

I think I read here some time ago that there was no legal reason why rent recieved had to be used to pay interest.

Correct.

That means you could use the rent as personal income and capitalise interest. This would make the whole loan tax deductable and make LOE a better proposition.

The rent would not be "personal income". Instead the rent is cash inflow to fund personal expenditure. From a Tax point of view (and therefore Income & Expense point of view) the Profit & Loss for the IP remains the same, ie Rent in less Cash out = Net Tax Gain/Loss for income purposes.

 

[Corsa]

I was planning to use it as a "debt recycling" strategy to pay down PPOR debt fast.

I believe you can still do this by reference of applicable tax laws.

I'll be interested to hear whether my strategy will need to be adjusted accordingly depending on any future ruling.

In retirement you can:

1. sell all assets live off the cash. Down side = no more growth
2. pay down all debt and live off rents. Down side = will the rents be enough?
3. live off equity capitalising interest on interest (and therefore deductible where in relation to investments) and using rents (and perhaps some capilised interest although this capitalised interest will be non deductible) to live off

The purpose of the original post was to try and explain how to make option 3 viable for retirement and/or escalating the repayment of PPOR debt.

 

[Corsa]

Agree, but up until now as far as I am aware, the ATO's position was that it's OK to capitalise interest (for an individual) as long as you are not trying to avoid tax and as long as you keep your investment loans seperated from your personal accounts etc.

Now the ATO seems to be saying that individuals cannot capitalise interest even if they have no personal debt, because it can always be argued that the purpose of capitalising the interest was so that the individual could continue to feed themselves whilst keeping their investments. Therefore an individual who has no personal debt and keeps all their investment accounts completely seperate from personal accounts, and uses the rent/dividends to pay down the investment debt, can still be caught out by the ATO because they capitalised their interest on one occasion due to needing to use their salary to pay for personal expenses.

Poppy, it is my opinion that this is an incorrect interpretation and I would seek to clarify this position with your accountant so you can maximise your tax situation.

The tax legislation is quite objective in that if an expense is incurred for an investment (ie an IP) then it is deductible. If an expense is incurred for a personal expense then it is not deductible.

 

[Corsa]

I wonder whether if not for the tax benefit, would using income from an IP to pay off a PPOR and use a LOC to pay IP related costs still offer any benefit at all?

The underlying purpose for pursueing this strategy of:
(a)channelling all available cash inflow (ie money from job or rents or tax return) into a PPOR or Lifestyle; and
(b)using borrowed funds to fund investments

Is for workers:
to free up cash to pay off your own home sooner (ie non deductible interest) and fund lifestyle choices. All the while maximsing the tax return available to them while they are working.

For retirees:
to fund retirement such that they dont have to sell the underlying assets and therefore erode there capital base and therefore the base of assets which is being used to fund retirement.

 

[Corsa]

Where one has no non-deductible debt and a positive, neutral or negatively geared IP portfolio, and one wishes to use some/all of the rents to live off (essentially living on rent retirement/semi-retirement strategy) and capitalise investment property costs including bank interest charges via a line of credit or similar (including where the portfolio becomes no longer positively geared if it was at the outset), the tax deductibility status of capitalised interest in this scenario seems somewhat more certain - clear and dominant purpose is driven by personal financial affairs/lifestyle decisions and does not point to a scheme to reduce tax (Part IVA).

A correction on the original thread which is now closed posted by SamA. This is not correct. The tax treatment of this situation is not more certain if the individual has no non-deductible debt.

The tax office looks at the purpose of the expense.

If the expense is for an income earning asset (ie in this case cost of IP's are being funded from LOC) then this is deductible.

If rents are being used to fund lifestyle and the cost of the IP's generating the rent are being funded by capitalised interest is not a recognised tax relationship.

If lifestyle is being funded by capitalised interest; even if the tax payer has no non-deductible debts; then this is considered domestic & private in nature and is no deductible against investment income.

 

[Corsa]

Is it possible to somehow use my personal savings (~$10k - $15k, a buffer so to speak) to offset interest in my IP loan?

That is noting that I will want to use this money for personal use at some stage in the short/medium term. Note I have no debt on my PPOR, only debt on IP. It would be nice to think it could sit in a personal offset account that is linked to my IP loan, but I'm not sure if this is allowed, or complicates the tax return.

This is allowed and does not complicate the tax return.

You may however effect your tax situation as with the offset reducing the interest on your IP loan you have less costs and therefore you may pay more tax in relation to your job income however given that the tax brackets have all changed and you need to earn over $180k etc to be in the top tax bracket then the impact on your tax is likely to be marginal.

By the sounds of it, parking your savings against your IP but in an offset so you can access the funds is the best strategy to follow.

 

[Corsa]

So the question is.....can all business income then be used to pay down personal debt, rather than fund business expenses?

ie. rents, dividends paid to PPOR debt?

Most would argue that you can do whatever you like with your income.

MJK

This is correct.

 

[Corsa]

It's not OK to capitalise interest on an IP loan, but it's OK to pay the interest on an IP loan using a Line of Credit and capitalise the interest on the LOC. Right?

So... if the same amount of interest is being capitalised, why is this capitalised interest tax deductible if it's in the LOC, but not if it's in the IP loan?

It's not OK to deposit all IP rental income into a PPOR loan, but it's OK to deposit all rental income into an offset account attached to the PPOR loan. Right?

So if the same IP rental income is being used to reduce the non-deductible interest on the PPOR loan, why is this OK when the rental income sits in an offset account, but not OK if it goes directly into the PPOR loan?

I'm just trying to look at this from an ATO perspective. If they allow one method, why don't they just allow all IP loan interest to be capitalised directly, and all rental income to go diectly into the PPOR loan? That is what is effectively happening with the structure suggested anyway, so why do we need the complex structure to make it acceptable to the ATO?

The 2 are one in the same. Typically the vehicle to capitalise interest on a loan is via a LOC. However you could easily do this via a Personal Loan, Credit Card, an IP loan drawn down into a bank account. It is okay to capialise interest on an IP loan via any of the above methods.

Equally for the rental income. It is okay for the rental income to go directly into the PPOR home loan or the Offset account. It is better to go into the offset account as this gives you the most amount of flexibility to use that cash for other purposes if necessary.

 

[Petal]

Ok call me a dummy but I have read these posts and I have read Julia's newsflash and I am still bloody confused.

Has the Hart's case been overturned?? i.e. can we now set up a structure that allows us to use rent money to pay down personal debt??

Can someone cleverer than me (not hard ) sum it up in one para that a simpleton can understand.

THANKYOU!!!!!!!!!!!!!!!!!!!!!!!

 

[ffc1883_1996]

Thank you for your wonderful contributions Corsa.

Petal, as I understand it, Hart’s case was in relation to a finance structure contrived specifically for the purpose of tax avoidance. From memory, their loan was a LOC, split in two (personal and investment) with a floating credit limit, that was advertised by the lender as being designed to minimise tax.

 

[Corsa]

I apologise in advance if Julia is a contributer on Somersoft, however after reading Julia's newsflash it is confusing as it is not written particularly well to explain the key concepts it is trying to get across.

In conjunction with my reading of the Tax Ruling & relevant tax laws what is important is:

1. Compound interest (interest on interest) is treated the same way that Ordinary Interest (primary interest) is
2. If the interest (compound or ordinary) is incurred for income earning purposes it is deductible
3. If the interest (compound or ordinary) is incurred for domestic & private purposes (ie to fund your own home or to fund lifestyle) it is not deductible
4. Hart's case primarily dealt with tax avoidance (which has been addressed in the first post on this thread
5. Hart's case didnt clarify whether compound interest was okay (which is why we have spent so much time debating & clarifying it on this forum) and this tax ruling TD2008/27 clarifies that compound interest is acceptable and is considered an expense the same way that ordinary interest is.

http://www.somersoft.com/forums/showthread.php?t=26532

 

[Rixter]

Hey Corsa,

Thanks for your posts.

Fantastic to see you back on the forum again - you have been greatly missed.

 

[Witzl]

petal - sounds like you are ok to use rent to pay down personal debt whilst capitalising the interest. yay

 

[Jonathon]

I apologise in advance if Julia is a contributer on Somersoft, however after reading Julia's newsflash it is confusing as it is not written particularly well to explain the key concepts it is trying to get across.

I believe she is a contributor. I know where you're coming from Corsa, but I think it's fair to say that Julia's newsletters make a lot more sense when read in the light of previous newsletters, as she tends to pick up on previous topics.

I personally find the free information on her site to be incredibly useful, but if I didn't then I'd ask for a refund...now how much did she charge me again?

 

[poppy]

Hi Corsa,

Thanks for your input, it's been a while since my original post but I am confused about the following comment;

No accounting mess. The capitliased loan interest on IP 1 in relation to IP 2 should be accounted for under IP 2 tax statements. The capilised loan interest in relation to IP 1 should not be accounted for under IP 1.

So say I have a loan for $150,000 on IP 1 at a low interest rate and a loan for $150,000 on IP 2 at a high interest rate. They are two totally seperate loans.

I choose to make extra repayments off the high interest loan for IP 2, whilst capitalising the interest on IP 1. This results in a % each year of IP1 loan having to be apportioned to IP2, as you suggested.

So, many years later I suddenly decide to move into IP2. At this time I have capitalised say $50,000 of interest into IP1 so that I could pay off IP2's high interest rate sooner. So, IP1's loan is now mixed with IP2's debt - but IP2 is now my PPOR and this debt is non-deductible. So, I think I now have a contaminated loan which is what I would describe as an accounting mess

Edit: I'll add that when you stated "The capitalised loan interest in relation to IP 1 should not be accounted for under IP 1", I've assumed you made a typo as this doesn't seem to make sense to me. I've assumed you meant "The capitalised loan interest in relation to IP 2 should not be accounted for under IP 1"

 

[jaycee]

poppy

this is how i read it.... I have an IP loan of $231k... I capitalise the itnerest via an LOC. The capitalised interest is claimed at each tax return as an expense.

end of story.

the rent from that IP, can go basically anywhere I like, even to pay down IP number 2.... but in reality, I'm not that smart, I only have 1 ip. so I have been putting the rent from IP #1 (which gets deposited by the tenant into my CBA savings account) into my PPOR loan. THis helps me reduce my debt on by $15600 pa.....

The interest on my original IP loan is about $17k (?).. so I claim this and the interest charged on my LOC.

I can't see how if my PPOR was an IP and I paid down the mortgage owing on it, would mean that the capitalised interest against IP#1 would get mixed up with IP#2

btw, I am hoping I read it right, so I am really asking if this is how it is, not telling anyone 'this is how it is'!

Now, I also pulled out another $2500 from the LOC used for IP#1 expenses to buy a few shares, anything wrong with that ?

 

[poppy]

the rent from that IP, can go basically anywhere I like, even to pay down IP number 2.... but in reality, I'm not that smart, I only have 1 ip. so I have been putting the rent from IP #1 (which gets deposited by the tenant into my CBA savings account) into my PPOR loan. THis helps me reduce my debt on by $15600 pa.....

The interest on my original IP loan is about $17k (?).. so I claim this and the interest charged on my LOC.

I can't see how if my PPOR was an IP and I paid down the mortgage owing on it, would mean that the capitalised interest against IP#1 would get mixed up with IP#2

My post is really just discussing my interpretation of the new ruling's wording and what I've said in my posts are not necessarily how I think things actually work. Certainly I will continue to claim all my capitalised interest as I have been!

 

[Terryw]

See also
Private Binding Ruling authorisation number 1011345133229
http://www.ato.gov.au/rba/content.asp?doc=/RBA/Content/1011345133229.htm