Capitalising Interest - How 'Aggressive' Are You?

[Shadow]

Just wanted to get an idea of how 'aggressive' people are regarding capitalisation of interest, and in particular, distribution of rental income. I have a fairly common structure as follows...

1. PPOR Loan secured by PPOR
2. Investment LOCs secured by PPOR and IPs (used for investment related expenses only)
3. IP Loans secured by Investment Properties

I direct my personal day job income towards my PPOR loan, and my rental income towards my LOCs.

I incur interest on the IP Loans, which the bank automatically deducts from the LOCs, and I also incur interest on the LOCs themselves. So the shortfall between the interest and the rental income is capitalised into the LOCs.

Some people go one step further and direct ALL income including rental income towards their PPOR loans, thereby capitalising ALL IP interest, and claiming this as a tax deduction.

There is no clear ATO ruling on the second arrangement. There are ATO rulings (PBRs) that cover the first arrangement (capitalising the shortfall only) and that acknowledge that this is a perfectly acceptable business arrangement, however the second arrangement (capitalising ALL interest) is a grey area.

The first arrangement holds up with the simple explanation that one does not wish to prop up ones business using personal income, however I really can't see any dominant reason for the second arrangement except to obtain a tax advantage, therefore I believe it might fall foul of Part IVA and be seen as tax avoidance.

I have discussed this several times with my accountants and they basically say it is a grey area and one where they recommend their clients to form their own judgement. As such, until now I have always played it safe and directed my rental income towards my investment loans.

Another factor to consider is the tax saving obtained as a result of negative gearing. Because I fill out the ITWV form, each time I get paid my pay includes a tax saving obtained as as a result of negative gearing, and I direct this tax saving towards my PPOR loan. However I know some other people who calculate the portion of their pay each month that is obtained as a result of negative gearing, and direct this portion towards their investment loans.

Interested to hear what others do and think about this topic...

Cheers,

Shadow.

 

[asdf]

Was doing this quite swimmingly for a over a year, funnelling rents and wages into offset account and capitalising like a man possessed. Alas the dream has come to an end. Better start tapping that offset account again. Great strategy... if you had endless equity.

 

[ffc1883_1996]

Some people go one step further and direct ALL income including rental income towards their PPOR loans, thereby capitalising ALL IP interest, and claiming this as a tax deduction.

That's what I do.

 

[BV]

Shadow is working for the ATO by the way...

 

[Bandita]

Rather than LOC's we ended up with additional loans against existing IP's. Those funds are in an offset account. We deposit the rents into the offset account and pay our IP loans from the same account. We don't have a PPOR yet - but I don't think we'd change it.

Cheers,
Jen

 

[Shadow]

What is the dominant purpose for distributing rental income towards PPOR debt.

A few questions for the people who capitalise ALL IP interest and direct rental income towards their PPOR loan...

1. Has your structure ever been assessed or audited by the ATO?
2. Did you get advice from your accountants that this was OK?
3. If the ATO asked you: 'Why do you distribute your rental income towards your PPOR loan?' ... how would you respond?

The reason I'm asking these questions, and why I started this poll, is because I want to move to this arrangement myself... I just want to find a better way to justify it. I have attached an interesting document (a few years old) regarding this issue. It discusses Harts case along with some alternative structures. Reading the document would suggest that the distribution of rental income towards PPOR debt is probably OK... but I still have a problem with Q3 above... what is the dominant purpose, if not to obtain a tax advantage, and is this a 'scheme'.

Cheers,

Shadow.

 

[ffc1883_1996]

1. Yes
2. No
3. Risk Mitigation – saving funds for my family to live from if required. In case I find myself unemployed, my structure will support itself for a while until I get going again.

 

[ruroshin]

3. If the ATO asked you: 'Why do you distribute your rental income towards your PPOR loan?' ... how would you respond?

Just stick the rental income in the PPOR offset account, its separate from the PPOR loan so you're not mixing it and you justify it by saying you're parking the money there until you see a good investment opportunity

 

[BV]

3. If the ATO asked you: 'Why do you distribute your rental income towards your PPOR loan?' ... how would you respond?

Shadow.

Shadow

That's a difficult 1.

If I was stretched financially which is not hard to do in a high interest environment, I would tell them that I did it so that I can afford to hold the IP's. Otherwise I don't earn enough money to pay the interest on the IP's as well as my PPOR.

It's a business decision I've made knowing that it is a short term solution until interest rates come down or my rents and/or my wages increase.

Cheers

 

[Mike F]

Some people go one step further and direct ALL income including rental income towards their PPOR loans, thereby capitalising ALL IP interest, and claiming this as a tax deduction.

I believe this is what some refer to here as 'debt re-cycling'

 

[ArJay]

I guess the next question is how will your SANF be if you're constantly worried the ATO might come a knockin' at some point.
Personally for me it wouldn't be worth it...

That said, perhaps a private ruling might be the answer? At least then you'd know where you'd stand...

R

 

[murtagh]

Surely income is income?

I don't have an IP yet, but I have shares. And I take their distributions and I spend it on candy canes and jellybeans. I don't think the ATO cares?

Cheers.

 

[murtagh]

A slightly different arrangement that is likely to be acceptable is where a taxpayer has a line of credit or bank overdraft for business purposes and also a home loan. If the taxpayer applies all spare income towards reducing the home loan whilst allowing the line of credit or overdraft to increase within its prescribed limit, Part IVA is unlikely to apply because the taxpayer is operating within the limits of a normal bank product. The taxpayer could operate the bank overdraft in this manner even if there was no home loan. There is nothing unusual or special about the arrangement

Seems to me, that paragraph (and the following example) says it's fine to capitalize interest if your loan facility allows that.

 

[BV]

Surely income is income?
I don't think the ATO cares?

Cheers.

Actually they have shown that they do care when it comes to property.

Generally speaking tax minimisation is legal while Tax avation is not.

They will decide the legality of our actions depending on what answer we give them so we should choose our words carefully.

Cheers

 

[Witzl]

Myself and my partner are currently capitalising all holding costs on our IP, as we are paying off a personal debt.
See here - http://www.somersoft.com/forums/showthread.php?t=43569&highlight=debt

Essentially it is the same thing as what you are suggesting, but on a much smaller scale.
We have the rental income going into our main bank account, paying down the personal debt. The mortgage on the IP has been refinanced with a redraw facility, and we have drawn out enough to capitalise the full holding costs for 6 months.

If the ATO asked why we are doing this, i would probably answer that this is the fastest way for us to reduce the personal debt, without redrawing from the investment loan and making a mess of the deductability of our investment loan - which would be much more work for our accountant and the ATO come tax time.
I wouldve thought this to be tax minimisation, and not tax avoidance - its almost a textbook example of the excerpt murtagh posted above.

Does that seem like a reasonable answer to the ATO?

 

[VCDenton]

I intend to jump in the first IP soon should be around middle or late next year.
In the light of possible years of stagnating property prices, do u experienced investors think that I should still get an interest only loan with extra money sitting in a linked offset account? or should I pay off some principal in order to lower my LVR?

Maybe someone should refresh me with the resoning why one should never payback a debt...

Regards
Vince

 

[jingo]

I intend to jump in the first IP soon should be around middle or late next year.
In the light of possible years of stagnating property prices, do u experienced investors think that I should still get an interest only loan with extra money sitting in a linked offset account? or should I pay off some principal in order to lower my LVR?

Maybe someone should refresh me with the resoning why one should never payback a debt...

Regards
Vince

Hi Vince,

If you set up an interest only loan with an offset account and put your wage and savings into the account then you are getting the best of both worlds. ie. The amount you put into the offset account will reduce your interest payments on your loan, and you can access your money in the offset account in the future for investment or private purposes.


Regards Jason.

 

[Rob G.]

I intend to jump in the first IP soon should be around middle or late next year.
In the light of possible years of stagnating property prices, do u experienced investors think that I should still get an interest only loan with extra money sitting in a linked offset account? or should I pay off some principal in order to lower my LVR?

Maybe someone should refresh me with the resoning why one should never payback a debt...

Regards
Vince

You expect your asset value to stagnate for a few years AND you want to capitalise interest ???????

Hope you understand the concept behind negative gearing vs capital gain.

Hope you also understand the concept of compund interest on your debt.

Rob

 

[davewill]

1. Has your structure ever been assessed or audited by the ATO?
2. Did you get advice from your accountants that this was OK?
3. If the ATO asked you: 'Why do you distribute your rental income towards your PPOR loan?' ... how would you respond?

I used this system and have paid off my ppor, now i place all income from wages, shares, rent, tax benefits etc into offset a/c on investment loans.
although i had been audited during the ppor stage my interest deductions were not questioned.

1. Not directly
2. No
3. I direct all income into a transaction account, then pay down loans as required by the loan aggreements.

 

[ArJay]

although i had been audited during the ppor stage my interest deductions were not questioned.

If you don't minf my asking, were they aware of your whole structure (ie that you'd paid down your PPOR loan etc)?

R