Interest on Interest and Capitalising Interest - the Facts

[bort]

I visited my accountant yesterday and ask him whether this method is allowed. My accountant told me that recently there is a case using this method being ruled illegal by the commissioner of tax. I remember he mentioned something like the Hart's case?? Do any of you know any about this case?

What the argument point is the rental income generated by the IP must go towards paying the outgoing costs (interest, fees, maintenance cost). If the rental income is not enough to cover the outgoing costs, then any money borrowed (and its interest) to cover the shortfall could be tax deductible. Please correct me if my accountant is wrong.

I was under the impression Hart dealt more with split loans - and making sure that when you are paying off debt (interest), it must come off both the deductible and non deductible debt. Rather than accruing interest on top of interest on the deductible side, and purely paying down your non deductible debt.

I would be very surprised if you were (or can be) forced to use any income for any specific purpose .. really does not make sense - but someone may prove me wrong! Say if you had no debt (or even if you had debt), and you receive rental income - no one can tell you that you need to use that on say council rates for the property, as opposed to buying a new porsche ....

 

[twodogs]

I visited my accountant yesterday and ask him whether this method is allowed. My accountant told me that recently there is a case using this method being ruled illegal by the commissioner of tax. I remember he mentioned something like the Hart's case?? Do any of you know any about this case?

What the argument point is the rental income generated by the IP must go towards paying the outgoing costs (interest, fees, maintenance cost). If the rental income is not enough to cover the outgoing costs, then any money borrowed (and its interest) to cover the shortfall could be tax deductible. Please correct me if my accountant is wrong.

Get another accountant !

 

[geoffw]

I visited my accountant yesterday and ask him whether this method is allowed. My accountant told me that recently there is a case using this method being ruled illegal by the commissioner of tax. I remember he mentioned something like the Hart's case?? Do any of you know any about this case?

Do a forum search on Hart's case- there's a lot in there.

That case was disallowed (I think) because it was ruled to be a tax avoidance scheme. There was no other economic reason for the structure.

But if there is a reason for the structure other than minimising tax then it may be allowable.

Seek professional advice- from somebody who has a little more knowledge than your existing accountant. Or, at minimum, educate her/him.

 

[Able]

I have been reading this thread with great interest. Here is some bedtime reading from the ATO site. Tax ruling from the Hart case.

http://law.ato.gov.au/atolaw/view.htm?locid='TXR/TR9822/NAT/ATO'

Regards
Alistair

 

[thedude]

AWESOME POST CORSA!!!! SIMPLY BRILLIANT!!! <3

Ive always wanted to do this type of structure however was unsure on whats right/wrong in the ATO's eyes. Great explanation, much appreciated.

Corsa,


While using an LOC account to fund an investment expenses account or loan account...we are saying the LOC interest is deductable.

My question is.. are regular repayments required to pay the LOC interest or is this interest able to accrue and compound without reduction. Interest on interest?

I am aware that most LOC's wouldnt allow no repayments. If this is the case interest payments from income will have to be made.

MJK

Are you able to answer MJK's question Corsa, as I have the same query?

Cheers,

Damon

 

[fgler]

What is the reason to do this if ATO knock on door?

Thanks for the reply.
Now I have read ruling against Hart's case, I know that this can be done.
But if ATO come knocking on door and ask why we have done this, what reason should we tell them?
Many thanks.

 

[Rixter]

Thanks for the reply.
Now I have read ruling against Hart's case, I know that this can be done.
But if ATO come knocking on door and ask why we have done this, what reason should we tell them?
Many thanks.

You tell them "Your" reason. You cant tell them anyone elses.

 

[MJK]

AWESOME POST CORSA!!!! SIMPLY BRILLIANT!!! <3

Ive always wanted to do this type of structure however was unsure on whats right/wrong in the ATO's eyes. Great explanation, much appreciated.



Are you able to answer MJK's question Corsa, as I have the same query?

Cheers,

Damon

Damon,

Curiosly we havn't had an answer. I hope my question was clear?

For your information Daman, the way I get around this is to have a Margin loan with Managed funds, A Margin loan is designed to capitalise interest till the cows come home if required! You can also use available funds as draw downs to fund property expenses or alternatively use fund distributions/ income to do the same without making loan repayments.

I'm sure others here use that approach.

MJK

 

[Able]

Damon,

For your information Daman, the way I get around this is to have a Margin loan with Managed funds, A Margin loan is designed to capitalise interest till the cows come home if required! You can also use available funds as draw downs to fund property expenses or alternatively use fund distributions/ income to do the same without making loan repayments.

MJK

MJK,
With a margin loan i presume as long as you have ample margin available then the lender will let you capitalise the interest. Do your also claim the interest as an expense in your tax return, even though it is being capitalised?

Any other feedback from other members who have this arrangement welcome.

I think it is useful looking at the margin loan due to the following similarities:

Margin Loan
- Capitalise interest (you are effectively funding the interest payment through further borrowings - which should all be tax deductable).
- Direct the dividends from the investments where ever you choose.

IP with Loan
- Fund interest payment with another LOC (all borrowings tax deductable)
- Direct the IP income (ie. rent) where ever you choose.

Regards
Alistair

 

[MJK]

MJK,
With a margin loan i presume as long as you have ample margin available then the lender will let you capitalise the interest. Do your also claim the interest as an expense in your tax return, even though it is being capitalised?

Regards
Alistair

Yes, that as I see it and yes I claim interest and yes in the future I will direct dividends to lifestyle but at the moment I reinvest.

My accountant who is very conservative has always said borrowings for shares can be capitalised.

MJK

 

[Corsa]

While using an LOC account to fund an investment expenses account or loan account...we are saying the LOC interest is deductable.

Yes MJK, this is correct.

My question is.. are regular repayments required to pay the LOC interest....or is this interest able to accrue and compound without reduction. Interest on interest?[/

My understanding is that you can accrue interest on your VLOC up until you reach your VLOC credit limit - so yes - interest on interest accrueing and compounding without reduction.

And then if 100% of this interest on interest can be directly traced back to the income generating purpose i.e a rental property, shares, or business then you are entitled to a full deduction for tax purposes. Or if only some of it relates to income earning purposes you will need to apportion the allowable deduction between private and business. This aspect was addressed in my first post on this topic.

I actually rang my bank CBA to confirm this so I didnt lead anyone down the wrong track on a VLOC issue that is really going to be a bank policy at the end of the day.

One thing to keep in mind is that the bank at first query may say you do have to pay a minimum repayment on a VLOC however question further whether you do infact need to i.e they contractually require you to or they just would prefer you to. Technically you coud just withdraw up to your credit limit or some of your VLOC into another account anyway and then pass this back into your loan so I think whatever you want to use your VLOC for up until the credit limit is acceptable with the bank - in line with the original intention you gave them for wanting the VLOC in the first place. So yes, capitilising interest should be okay.

Ultimately from a tax point of view you do always need to intend to pay back the loan evenutally so this should always be part of your reasoning for doing things anyway.

Hope this helps

Corsa

 

[Corsa]

My accountant told me that recently there is a case using this method being ruled illegal by the commissioner of tax. I remember he mentioned something like the Hart's case?? Do any of you know any about this case?

Harts case is commonly discussed on this forum and is a great example of how not to set up your accounts. Particularly as the tax office treats it as a scheme and disallows deductions per TR98/22

Let's consider the facts firstly of Hart's case.

1. It involved a typical linked or split loan facility comprising of two or more loans or sub accounts.
2. One is typically for private purposes and the other(s) for business purposes
3. Repayments are allocated to the private account and the unpaid interest on the business account is capitalised
4. this maximises the interest deduction by creating interest on interest

So if you have some of these factors in place in your own situation, then your accountant is correct - Hart's case may apply and you will need to apportion your interest deduction between private and personal expenditure and investment expenditure.

The anti avoidance provision was relevant here because the facility was considered

1. a planned course of conduct designed to produce a tax benefit
2. the structure of these facilities is designed to produce additional interest deductions;
3. the facility is marketed in a manner that emphasises the associated tax benefits;
4. an accelerated payment of the private account and a corresponding increase in the amount owing on the investment account;
5. an absence of commercial reasons for capitalising the interest;
6. the rates of interest charged on loans under the facilities may be higher than the rates available under a separate loan structure.

I think it was pertinant in TR98/22 at point 83:
We accept each case must be considered on its merits and, in the absence of other considerations, the choice of repaying non-deductible debt before deductible debt is a normal commercial decision. However, we have examined the way these particular facilities are structured and have concluded they are not ordinary arrangements and they bear the stamp of tax avoidance

This wraps up this issue as far as I can see. The tax office is fine if you commercially decide to do whatever you want with your money and minimise tax.

However if these factors exist :

• if you have a split or linked loan set up similar to Hart's case or
• there is no link between the expense to an income earning purpose or intention or
• if you have a line of credit facility where you treat all repayments payable to the personal debt and not proportionately between investment and personal (TD1999/42) or
• if you have a line of credit where you claim the whole deduction even thought some relates to personal and investment (TD1999/42)

Then you may experience some issues with the tax office regarding your claims and/or your structure is not set up correctly.

What the argument point is the rental income generated by the IP must go towards paying the outgoing costs (interest, fees, maintenance cost). If the rental income is not enough to cover the outgoing costs, then any money borrowed (and its interest) to cover the shortfall could be tax deductible. Please correct me if my accountant is wrong.

If this is the reasoning your accountant gave you then it is unfortunately incorrect.

However this is the "traditionally" accepted way of doing things so I can understand your confusion (and your accountants) but dont confuse the traditional view with "having to do it this way" from a tax or legal point of view in accordance with the currently applicable and relevant tax laws.

Hope this helps

Best Wishes

Corsa

 

[Corsa]

But if ATO come knocking on door and ask why we have done this, what reason should we tell them?

In applying the tax laws in accordance with ITAA97 s 8-1 which allows a deduction for all losses and outgoings to the extent to which they:

(1) are incurred in gaining or producing assessable income (the 'first limb')
(2) are necessarily incurred in carrying on a business for the purpose of gaining or producing such income (the 'second limb')

No deduction is allowed under s8-1 for expenses to the extent to which they are of a capital, private, or domestic nature

What this means is all your reasons and intentions need to link back to these basics somehow.

Clearly there is a thousands of interpretations on all of the above both objectively (via case law) and subjectively (by an accountants application of the tax law) but at essence if you keep this at the fore front of your mind when conducting your business efforts you should be able to set up the necessary links between income and expenditure to substantiate your claims should you ever be audited and to ensure your efforts are appropriate and integral in accordance with the relevant tax laws.

 

[redwing]

When I initially read Corsa's post it was a bit unclear; things are now getting a bit clearer though and I see it now as;

Salary -------------> Housing/Working Account

IP Rent -------------> Rental Income Account

IP Costs and Interest <----------------------------------------Property Cost A/C --> Link to LOC

At its most basic.

* Investment Income into Rental Income Account to Offset personal debt (none for us, so we could offset on an IP if we "really" wanted to) and Fund Lifestyle in the future.

* Debt to fund the IP Portfolio because it improves the tax situation.

*** At this stage though I would pay monies from the Rental Income Account into the Property Cost A/C as we are not big enough yet to be self sustaining.

And we live off our wage (as per the norm until LOE becomes an Option)?

In our situation though I Haven't factored in my Managed Funds via LOC or the Income Dividends coming back in yet and the HDT account.


Does the above look correct?

 

[gooram]

Can someone proof read this example that shows how much this could save you?

You are essentially introducing an ever increasing interest repayment.
You need to be sure that this new interest payment is less than the money saved by having the extra dollars in your offset account. I would say that as your PPOR debt reduces, and your LOC balance increases, this scheme becomes less beneficial?

E.g.
Lets say I take home $50k pa.
Lets also say I had one IP with an outstanding loan of 200k and a rent of $200pw and a PPOR with an outstanding debt of $200k.
My finances are structured such that I have an offset account against my PPOR loan with 50k, and I have a LOC for all IP interest payments and expenses. All rental and salary income is paid into the offset account.

Excluding other expenses...
At the end of year 1:
Offset account balance is 50+50+(200*52)=$110,400
PPOR loan repayment (at 7%) is $6272pa
IP loan repayments come out of LOC.
LOC (now at $14k - 200k @ 7%) repayments are $980pa before tax, $686 (after tax assuming 30%)
Net position $6958pa

If you didn't have this structure...
At the end of year 1:
Offset account balance is 100k
PPOR loan repayment is $7000pa
IP loan repayments are (14000-(200*52) ) $3600pa before tax, $2520 (after tax assuming 30%)
Net position $9520

So capitalising interest in this simple example would save you $2562 in the first year

I realise it's hard to get a true figure because it's changing on a potentially daily basis and not at annual increments, but this gives an indication.

 

[gooram]

By the way, where do the LOC interest payments come from? Which account?

Let's say in another 2 years the PPOR debt is completely offset by the funds in the offset account.

So now you have your IP loan of 200k and a LOC balance of $42k.

Now what? Start funnelling income and rent into these debts? I assume this is the goal, or buy another IP with all your new found cash flow and continue to increase the balance on the LOC?

 

[asdf]

All you're doing by capitalising interest and IP expenses is coverting a 7.15% interest rate to 3.83% for tax rates at 46.5%, 4.90% for 31.5% on a post tax basis. And then building up a war chest of cash so when you decide to switch PPOR, you don't have to sell or re-draw equity. You can just withdraw it all out from off-set account and whack down large deposit on PPOR and then start again. Yes, it means you keep on borrowing but I once heard the wealth of a man is measured by how much debt he has or something like that....

 

[redwing]

I dont believe (or at least the bank tells me) that you can direct debit a LOC, so this means your Property Costs account would have to be topped up manually (in my situation) would it not?

 

[Corsa]

*** At this stage though I would pay monies from the Rental Income Account into the Property Cost A/C as we are not big enough yet to be self sustaining.

And we live off our wage (as per the norm until LOE becomes an Option)?

Does the above look correct?

Hi Redwing

Yes the above does look correct : )

Cheers

Corsa

 

[ChrisOs]

I dont believe (or at least the bank tells me) that you can direct debit a LOC

I guess it all comes down to the particular bank and limitations on the account redwing because my investment LOC is with BankSA and I pay the interest on that each month through a direct debit.

Regards,
Chris.