Interest on Interest and Capitalising Interest - the Facts

Discussion in 'Accounting and Tax' started by Corsa, 28th Jun, 2006.

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  1. Corsa

    Corsa Member

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    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:
    1. acquire income-producing assets (eg property for rental, shares for dividends: ID 2003/841)
    2. to finance business operations (eg as working capital) or
    3. 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or split loan facility or a line of credit where it used 70% for business and 30% for personal (based on actual amounts withdrawn for those purposes) then you will have to apportion your interest incurred accordingly.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:
    1. the interest is not preliminary to the income earning activities (ie it is not incurred too soon)
    2. the interest is not of a private or domestic nature
    3. 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
    4. 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.
    1. have all salary deposited into a Housing A/C account and channel that money wherever it needs to go
    2. channel all rental income into the Rental Income A/C
    3. link the Rental Income A/C as an offset to your PPOR loan (if you still have one) or link it to another loan
    4. set up a separate Property Cost A/C and take all property costs and property interest from this account
    5. 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
    6. 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.
     
    Last edited by a moderator: 17th Jul, 2007
  2. DaleGG

    DaleGG Member

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    Hey Corsa!

    What an absolutely brilliant post!
    Thank you sooo much for sharing this. It makes fantastic sense.

    Dale
     
  3. grossreal

    grossreal Member

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    hi Corsa
    great post and very interesting reading.
    couple of question.
    the Property Cost A/C
    any problems you see in that being a credit card account that pays the bills and gets paid off at the end each month before its due.
    the rest I understand and is very good information.
    whats the difference in the post between using a split loan and having the two account numbers and having the interest split and they send out two statements(nab) and a loc where you are paying for the loc charges.
    I find the split loans cheaper to run then loc.
    In your opinion what has the loc got over the split loan, allowing that you split your ppor and your ip loans and are using that split loan to leverage.
     
  4. WillG

    WillG Member

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    Nice thread.

    The only problem I see, is claiming interest on interest incurred on the Property Cost A/C. The Property Cost A/C isn't generating any income so this wouldn't fit with the guidelines
     
  5. ILoveProperty

    ILoveProperty Member

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    Hi Corsa
    Thank you for taking the time and effort to write your post.
    Really cleared it all up for me.
    Great stuff!
     
  6. Corsa

    Corsa Member

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    Sorry Will. I have to use you as the guinea pig :)

    In my post I highlighted that the underlying security of the loan is not relevant. The same would apply for the Property A/C.

    There are two things in a transaction -
    1. the first is the origination (the security)
    2. and the second is the purpose of the transaction.

    It is the purpose that is important and the security it totally irrelevant (TD93/13).

    In your scenario the property a/c is the security and therefore what you do with that account interest earning or otherwise is not relevant. It is the way you use the money in the Property A/C towards what purpose that is important.

    I can only show you by way of example.

    Scenario 1
    1. LOC secured by your PPOR
    2. You use this LOC to fund another investment property costs - LOC interest deductible
    3. You use this LOC to fund another investment property interest repayment - LOC interest deductible
    4. You use this LOC to fund your overseas holiday - LOC interest not deductible

    Scenario 2
    1. LOC secured by your Investment Property
    2. You use this LOC to fund another investment property costs - LOC interest deductible
    3. You use this LOC to fund another investment property interest - LOC interest deductible
    4. You use this LOC to fund your overseas holiday - LOC interest not deductible

    Scenario 3
    1. Property Cost A/C that you pay your property expenses and property interest out of
    2. You use borrowed funds each month from a LOC 7%, Credit Card 18%, Personal loan 12%
    3. You take money from your borrowed funds source and deposit into your Property A/C each month
    4. You use the Property A/C money to fund another investment property costs - Borrowed Source Tax Deductible
    5. You use the Property A/C money to fund another investment property interest - Borrowed Source Tax Deductible
    6. You use the Property A/C money to fund fund your overseas holiday - Borrowed source not deductible

    The key themes here are:
    1. interest on interest is deductible to the extent the purpose of the borrowed funds is to fund an income producing purpose
    2. the source or the security is not important at all
    3. where you can clearly demonstrate the connection between the borrowed fund source and the purpose of the use of the funds (ie towards investment property etc) then it is deductible
    4. where you can clearly demonstrate the connection between the borrowed fund source and the purpose of the funds as private and personal - this is not deductible

    Best Wishes

    Corsa :)
     
    Last edited: 28th Jun, 2006
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  7. Rystar

    Rystar Member

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    hey Corsa thanks for all the time and effort put into this post. great info.

    one question, with example.

    does it matter is the housing account and rental income account are the same account, and that account is offset to the PPOR?

    eg.

    PPOR offset account - ALL income is put into this account. personal income, rental income. this account is used to pay personal credit cards and all personal expenses etc.

    PPOR account - only has interest charges and P&I/IO payments

    IP account - only has interest charges and interest payments

    LOC - secured by either PPOR, IP or both IP and PPOR - all IP expenses and IP interest is paid from here.


    I actually started looking into this structure last week.
    cheers
    Rystar
     
  8. lizzie

    lizzie when i grow up ...

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    1. fantastic post corsa - thanks so much for your time. this was the bit i was interested in and makes me a very happy investor (cause that is what i have been doing, but was worried i couldn't claim).

      thank you thank you thank you
     
  9. Corsa

    Corsa Member

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    No this is fine.

    So you could:
    1. pay for property expenses on your credit card and pay this off on the due date from the property a/c or say a LOC
    2. with respect to the property a/c if you just have cold hard cash in their then there is no additional deductibility for interest borrowings to fund the financing of invesment costs (ie your property costs)
    3. with respect to the property a/c if you use money from a borrowed source - then the interest would be deductible as well

    The main reason why you would use borrowed funds as opposed to cold hard cash is if you still have a PPOR or Consumer debt you need to pay off or you wanted to fund lifestyle choices ie LOE or holidays etc.

    I would ask one of the mortgage brokers on the forum what advantages a split loan has over a LOC but from an accounting point of view as long as you are apportioning your interest correctly and not channelling all P&I or I repayments into private and non deductible debt and capitlising interest on the investment side you should be fine and Harts case should not apply and ITAA36 Pt IVA for tax avoidance would not apply.
     
  10. Corsa

    Corsa Member

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    No this is fine particularly if you have this linked as an offset against your PPOR. Although keeping it separate is also just as fine.

    This is the way to do it then all LOC interest should be deductible. Try not to cross collaterise if you can avoid it by having LOC secured by only one property - probably the one that will give you the biggest limit so you can buy more property or capitalise your expenses for longer.
     
  11. Tasman

    Tasman Member

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    Corsa, great post and thanks for clearing up the reference to separate income accounts.

    I have a structure such as Rystar outlined, and had concerns over why private income should be deposited into separate account from investment income. I assume you may be now referring to separate account statements assisting in management reports. However my basic recording software (MS Money) readily separates income sources by categories and classifications.

    There is a strong reason to combine income sources into one account when you have a PPOR loan, as you can normally only get one Offset account with a mortgage account. So to maximise offset benifits for the PPOR loan, pooling all revenue into one offset account seem to be very efficient.

    Cheers Tasman
     
  12. Corsa

    Corsa Member

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    No, this was not the reason. Budgeting was probably the main reason. I dont want to be spending my investment income just yet and lumped in one account would get tricky for me personally.

    I think it is fine to keep them separate or have them together - whatever works and it makes no difference from an accounting tax perspective really.
     
  13. grossreal

    grossreal Member

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    hi corsa
    thanks for the reply.
    my question was to see if I also was on the right track and it seems I am.
    thanks for the post and this type of post is avery good example for people that have got a very good understand of a subject to post so others can ask questions even if it is just to check there own position
    and for that I thank you.
     
  14. emu

    emu Sticky-beak

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    Corsa great post you ROCK
     
  15. thefirstbruce

    thefirstbruce -

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    If everyone shut up until they had something profound and factual to say, then this thread deserved to be shouted.

    Thanks for taking the time to write it...
     
  16. Cheeks

    Cheeks Member

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    :D :D BRILLIANT :D :D
     
  17. willy1111

    willy1111 Member

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    Hi Corsa,

    Thanks for taking the time to do your post. I think I have understood what you have said - but just to be sure I have created an example with diagrams and figures which I have attached.

    Could you take a look to see if this is what you are saying.

    Cheers

    Tim
     

    Attached Files:

  18. WillG

    WillG Member

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    Not sure what you mean by this.

    The crux as I read it is (please correct me if I am wrong) ...

    You can claim the interest on a loan used to pay interest & expenses for an investment property
     
  19. Corsa

    Corsa Member

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    Yes this is correct :)
     
  20. Corsa

    Corsa Member

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    Yes this looks right :)
     
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