Dear All This post was prompted by the number of threads that have been coming up lately seeking to clarify the treatment of Interest on Interest and Capitalising Interest concepts and in general how to deal with interest. Interest is deductible to the extent to which it is incurred in gaining or producing assessable income or in carrying on a business for that purpose and is not of a capital nature ITAA97 s 8-1. Interest is not normally a capital outgoing because it is recurrent in nature and does not secure an 'enduring advantage' rather it simply secures the use of borrowed money during the term of the loan. This applies even where the borrowed funds are used to purchase a capital asset (Steele) Interest on borrowed moneys may be deductible where the moneys are used to: acquire income-producing assets (eg property for rental, shares for dividends: ID 2003/841) to finance business operations (eg as working capital) or to meet current business expenses (eg overdraft moneys used to pay business outoings like rates, water, management, legal fees etc) The security given for the borrowed money is totally irrelevant (TD93/13) If you have a linked or split loan facility or a line of credit where the funds are used 100% for the purposes of generating income then 100% of your interest will be deductible. If you have a linked or split loan facility or a line of credit where it used 70% for business and 30% for personal (based on actual amounts withdrawn for those purposes) then you will have to apportion your interest incurred accordingly. So if you have a Line of Credit with $100,000 drawn down for the whole year so 365 days (or 366 for a leap year). $70,000 for business and $30,000 for personal. Then assuming a 7% (so a daily rate of 0.01918%) the interest applicable will be: Investment = $70,000 * 0.01918% * 365 days = $4,900 deductible Personal = $30,000 * 0.01918%* 365 = $2,100 not deductible Total Interest = $7,000 If you have a Line of Credit with $100,000 drawn down for the whole year. $70,000 for business and $30,000 for personal. But you pay off $10,000 reducing your LOC balance to $90,000 on day 301 of the financial year. The calculation will be as follows: Investment = $70,000 * 0.01918 % * 300 days + ($70,000 - ($70,000/$100,000)*$10,000)) * 0.01918% * 65 days = $4,028 + 785 = $4,813 deductible Personal = ($30,000 * 0.01918% * 300 days) + ($30,000 - ($30,000/$100,000)*$10,000)) * 0.01918% * 65 days = $1,726 + $337 = $2,062 non deductible Total Interest = $6,875 Refer TR 92/22 for more information on linked or split loans and TD 1999/42 for LOC. Connection with income of later years (ie you buy land or assets that dont produce income immediately). Interest on funds used to purchase a property on which the taxpayer intends to build an income producing asset may be deductible from the time of acquisition of the property (Steele's case). The key factors to take into consideration include: the interest is not preliminary to the income earning activities (ie it is not incurred too soon) the interest is not of a private or domestic nature ther period prior to the derivation of income is not so long that the required connection between the outgoings and income is lots the interest is incurred with one end in view, namely the gaining or producing of assessable income continueing efforts are undertaken in pursuit of that end So what does all this mean for us property investors. Well firstly, if you pay for property expenses totalling $20,000 out of your Line of Credit for the year (assume 100% used for investing) then the interest should be 100% deductible. The contenscious bit, if you use your LOC to pay for interest on another investment loan totalling $10,000. Is this interest deductible? I would argue that it is under ITAA97 s 8-1. Harts case effectively precluded the deductibility of compund interest under a split loan facility where you channel the whole P&I or I repayment into the personal component and not into the Investment component and still want to claim 100% of your interest. So what would be the perfect set-up? This is particularly important for those who still have a loan on their PPOR and want to find the cash to pay it all down without having to sell one of their investments to do it. have all salary deposited into a Housing A/C account and channel that money wherever it needs to go channel all rental income into the Rental Income A/C link the Rental Income A/C as an offset to your PPOR loan (if you still have one) or link it to another loan set up a separate Property Cost A/C and take all property costs and property interest from this account technically you could draw down on any form of finance to meet your committment each period for the amount that comes out of your Property Cost A/C (ie LOC, personal Loan, credit card) and these borrowings from those sources would be deductible because they were being used for investments that generate income or even if in the early days you are simply just transferring the money from the Rental Income A/C to the Property Cost A/C then that is okay. Its the structure and separation that is important initially and this will help on LOE strategies down the track What this set up is affording you is to enable you to live off equity down the track and provide a tax effective scenario where your investments are funded by debt and your personal expenses are funded from investment income. In addition to that, it is also turning non deductible debt (ie PPOR or holidays in france) indirectly into deductible debt by the way you are channelling money around. Also, the point about the security being irrelevant way up the top - that is meant to point out that even if you have a LOC secured by your investment property but you are using the LOC to fund PPOR or personal expenses this does not make the LOC interest tax deductible. Nor can you pay off a PPOR using your LOC secured by anything and have this interest deductible. You have to always look at the new purpose of the loan. Which is why LOC where everything gets put into the pot makes things so confusing. I would always recommend to people to get an official opinion from their accountant because everyones situations are so unique and different and that is partially why it can get confusing in applying some of these concepts in practice. The last point, I am happy to field any questions on this post or have someone who is qualified to add to this or for comments to be made or people to point out all the reasons why I am wrong But given we have had so much confusion on this topic alone and constant queries from people on how to capitalise interest or to turn bad debt into good without selling - lets face it - we all want to do it - but legally within the contstructs of the tax law. In the nicest possible way, some people responding to these queries merely say "i think it is okay.." or "i think you cant capitlise interest..." and I think this is adding to the confusion. I would rather not see the confusion continue on and I hope that this is okay with everyone. Best Wishes Corsa Edit by mods: This information is of a general nature only and may not apply to particular circumstances. This is not tax advice- please seek professional advice on any strategy mentioned. By making this thread a sticky, Somersoft are nor providing tax advice.