Loan Contamination

Discussion in 'Accounting and Tax' started by albanga, 5th Jun, 2015.

  1. albanga

    albanga Member

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    Hey Experts,
    I am trying to find the answer to a question but still am not clear or have a definitive answer. It is likely I am not explaining myself correctly so I will try to be as clear as possible. I am trying to understand and determine if the following scenario would result in loan contamination.

    You have no PPOR
    You have a IP1 with a loan amount of 200k. You refinance the loan and at the same time get access to an additional 50k of equity. You do not get a split loan and at the time of settlement the lender puts the additional 50k into the offset linked to IP1 loan.
    Now at this stage you can claim an interest deduction on the 200k, the 50k you obviously cannot.

    So now the tricky part, say you have 40k in savings and since you have no PPOR debt the best place would seem to be the offset so you place it in there. Now from my understanding this is loan contamination, you have mixed "potentially" deductible debt with non deductible debt. You can now claim interest on 160k.

    But this is where I get unsure. What happens if the 90k in the offset never falls below 50k? Meaning in essence you never touch the 50k of loaned debucticle debt, you only spent your personal savings.

    Eventually you buy IP2 with 50k from the offset.
    So would this 50k now be deductible or contaminated?
    I mean in the eyes of the ATO can they see 50k went in at settlement, a lot of transactions then took place but none that went below 50k and that was then eventually used for a deposit?
     
  2. Paul@PFI

    Paul@PFI Tax, SMSF & Planning

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    This is a blended loan example and yes it can be a problem. In the example given it WOULD render some non-deductible. Offsets are not a deductible use. It would be easier if the (new) loan split had a separate offset OR redraw. After the bank puts the $ into offset you repay the loan and the redraw when needed. Otherwise, If ATO review it and they cant understand or agree with your calculations they would deny the interest deduction in full and allow you to object.

    I like the example of a credit card to illustrate the issue. For someone who doesn't pay it off how can you identify the interest attributable to a $500 cost ? Easy in month one and then it all gets hard. You cant allow that $500 of the balance remains due. All the card use and repayments and interest get apportioned and the % will constantly adjust. The more activity the worse the problem gets.

    Simple solution - Don't blend. Keep use separate.
     
  3. albanga

    albanga Member

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    Thanks heaps Paul. I guess for myself and maybe a number of others on here, we understand the concept of loan contamination, in its simplest form it's the mixing of deduticle and non deductible debt.

    But understanding what that means in terms of taxation is where it all gets confusing. For example I am sure you have had clients with contaminated loans that actually was not an issue. for example it was only for a single year and you were able to fix it easily enough. Then I am sure there are others that are basically unfixable or if they were the cost of your time working it all out would outweigh the benefit?

    So in my scenario, If the lender only allowed 1 offset then you would immediately pay the 50k into the redraw and then move your savings in keeping them seperate. When you want to then access that 50k get a new split at the time?
     
  4. Perp

    Perp Member

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    Wouldn't there only be a problem if the situation was a *redraw*? If he's parked funds in the offset, he can use it for whatever he damn well likes and the interest on the $200K loan is always deductible.

    The interest on the extra $50K of the loan is never deductible, because it was never borrowed for a deductible purpose.

    Edit: Clearly it will get complicated if albanga wants to pay down principal. The best thing to do is split it in the $200K and $50K portions, and have the $200K deductible, and the $50K non-deductible. Then albanga can pay down the $50K first.
     
  5. Peter_Tersteeg

    Peter_Tersteeg Finance broker/strategist

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    Move the money from the equity release from the offset account to the redraw facility of the loan. If you do this before you put other money into the offset account you should avoid the contamination problem.

    Once that's done, you can do business as usual with your savings in the offset account.

    Simple rules on where to park money:

    Equity borrowed = Redraw of loan you used to borrow the money.
    Income earned = Offset account.
     
  6. Terry_w

    Terry_w Member

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    I can?t understand why you would set your loan up like this at all after all the posts we have shared about loan structuring.

    This is really confusing to work out. It is best thought of as one big LOC type loan as the same principals apply.

    Day 1 $200k Loan
    all relating to the investment property, all interest deductible.

    Day 2 $250k loan,
    $200k relating to the investment property. Consider the $50k as undrawn and the limit now $250,000

    Day 3 $40,000 deposited.
    This will come off the $200,000 loan drawn. So only $160,000 of this loan will be deductible.

    This is the generous interpretation assuming the best case scenario.

    My advice is to immediate split the loan into 2 portions
    $200,000
    $50,000

    Get an offset on the $200k to park the $40k.
     
  7. albanga

    albanga Member

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    Thanks for clarifying all.

    @Terry - I have not structured like this, it is something I am just having difficulties getting my head around. I honestly think I understood it better before I spent so long in the finance section of the forum but as you read more you start to ask more questions and think "I get it, but what about in this scenario".
     
  8. chunho01

    chunho01 Member

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    I'm also quite confused by this contamination topic... :( My quite simple case:

    Offset-account: Against IP. All expenses and income go in and out of this account

    Doing a re-valuation, and was told that the equity pulled out will be added to this same offset-account.

    Will this cause the contamination issue?
     
  9. Perp

    Perp Member

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    Yes, if you're not using the equity pulled out for investment purposes.

    You need to have the extra that you pull out in a different loan account, if you want to retain deductibility of the interest on the IP loan.
     
  10. Terry_w

    Terry_w Member

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    Yes definitely will contaminate. Who told you this?
     
  11. chunho01

    chunho01 Member

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    My broker :( I did not ask him to elaborate, so it could be my own misunderstanding. So for eg, if I added $27k, where would that money be 'parked' so that I can still offset and not paying the full interest. How would my structure look like?

    Good thing the application hasn't been lodged yet.

    Current:
    Offset account
    Fixed Loan portion
    Variable Loan portion
     
  12. Jess Peletier

    Jess Peletier Mortgage Broker, Perth

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    Time for a new broker by the sounds of that. Too many brokers have no understanding of the tax implications of what they're setting up.
     
  13. Terry_w

    Terry_w Member

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    Keep good records so you can use them in evidence later if need be.

    You should not be borrowing to park in savings accounts, but setting up a new split and keep the money 'in' the loan so that you borrow when you need it.
     
  14. chunho01

    chunho01 Member

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    So you are suggesting that the new situation would be:

    Offset account (savings; offset against variable portion)
    Fixed Loan (negative amount)
    Variable Loan (negative amount)
    New Variable/Fixed Loan (neutral/no amount, but with a drawable limit???)

    What is the term for this? How can I verify if my broker is doing like this?
     
  15. Terry_w

    Terry_w Member

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    Yes you would need a new loan, with a separate loan account number. You wouldn't want a fixed loan as you could not deposit and redraw. A LOC may be the way to go, depending on the lender.

    When your loan documents come if they are not set up correctly then don't sign but ask for them to be set up as instructed.
     
  16. bumblegoodie

    bumblegoodie Call me BG

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    does anyone knows whether which banks provide free sub-accounts to prevent loan contamination?
     
  17. Terry_w

    Terry_w Member

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    You don't need a sub account but a separate loan, which all lenders offer.
     
  18. bumblegoodie

    bumblegoodie Call me BG

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    hi Terry,

    sorry i wasnt clear. Iam also talking about top-up.

    For example:

    1. Exisiting loan $300K

    2. Re-val / Re-finance with top up equity $100K

    3. So the new $100K would go to the sub-account to prevent loan contamination?

    Is this correct?
     
  19. Terry_w

    Terry_w Member

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    I was talking about a 'top up' too - doesn't matter what you call it, you are borrowing more money which should be done via a separate loan. Otherwise you will have a mixed purpose loan with tax problems.
     
  20. windyzz

    windyzz Member

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    When i set up my account with NAB. They do this automatically

    1. Loan Account and
    1. Offset 100% account.

    Have no idea what to do then.. All the extra equity is in My Offset account including my salary + other expenses.

    This is the setup that NAB did for me when i move from CBA...