Tax deductability of LMI

Discussion in 'WebBoard Property Investor Forum Archive' started by Rolf Latham, 10th Sep, 2002.

  1. Rolf Latham

    Rolf Latham Member

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    From: Rolf Latham


    Hi all you tax people :eek:)

    Scenario:

    Client has 20 % deposit and wants to buy PPOR. Becuase only 80 % loan no lmi payable.

    If however he/she borrows at 90 % and uses the other 10 % for the purchase and costs of an investement property the LMI premium on the PPOR loan would in my view be a deductible (or depreciable as borrow cost) item.

    My logic (heheh tax office and logic) flows from the fact that the SOLE reason for the 90 % PPOR loan is to preserve equity for a purchase which will derive income.

    Many bean counters feel that the LMI used to secure the PPOR is NOT tax deductible/depreciable because the funds are private usage - I dont agree.

    Thoughts please ?

    Ta

    Rolf
     
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  2. Rixter

    Rixter $uper Investor (Retired)

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    From: Rixter ®


    Rolf

    Get a private ruling so its in black & white. That way no disputes can arise later.

    [​IMG]©

    Happy Investing,
    Rixter® :)
     
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  3. Richard Hunt

    Richard Hunt Member

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    From: Richard Hunt


    Rolf,

    I'll stand with the conservatives!

    The LMI premium is incurred as a direct result of the money borrowed for the PPOR. As a borrowing expense is only deductible to the extent that the borrowed money (to which the expense relates) is used to produce assessable income, then no part of the LMI would be deductible.

    Regards
    Richard
     
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  4. Rolf Latham

    Rolf Latham Member

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    From: Rolf Latham


    Hi Richard

    Thanks for that. That is indeed the traditional view. My argument is that the LMI premium would not be incurred but to fund the related purchase of an income producing asset - unlikely to hold water though.

    Looks like we are back to charging the client a rebatable brokerage of 1.5 % on the investment property then, so that they get the equivalent of a deductible premium.

    Ta

    Rolf
     
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  5. DaleGG

    DaleGG Member

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    Reply: 1.1.1.1
    From: Dale Gatherum-Goss


    HI

    I can see both arguments. The 10% that threw the loan into LMI is for investment purposes and so it might be claimable.

    However, if I was going to go down this path, I would ask my client to write a letter to the relevant, friendly mortgage broker explaining that the first %age of funds would be used for PPOR and the balance would be used for investment purposes.

    This way, there is something concrete on the broker's and lenders files that supports the case.

    Even then, LMI is a borrowing cost and is written off over 5 years or the life of the loan, whichever is shorter.

    I hope that this helps.

    Dale
     
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  6. Rolf Latham

    Rolf Latham Member

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    Reply: 1.1.1.1.1
    From: Rolf Latham


    Hi Dale

    Thanks it does help. I wasnt looking for a concrete answer - we all know at the fringe there is no such thing.

    The depreciability but I was obviously aware of, as with all borrow costs.

    What about this way, Dale and Richard ?

    Client buys at 80 %. Refinance to 90 % ASAP using the proceeds as deposit and costs to aquire an income producing property. In this instance there is a clear and undeniable (hehehe) linkage between the LMI cost incurred and the investment funds. Again Many of my clients advisers have split the premium according to the % of PPOR and Investment split debt. Again I would argue that the SOLE reason for the LMI is to get the extra 10 % equity for aquiring the IP.

    Ta

    Rolf





    Rolf
     
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  7. DaleGG

    DaleGG Member

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    Reply: 1.1.1.1.1.1
    From: Dale Gatherum-Goss


    Hiya Rolf

    I agree wholeheartedly and would be prepared to claim on that basis. Mind you, I would emphasize the need to document the who, what's, where's when and why's.

    Have fun and great discussion, Rolf

    Dale
     
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  8. Richard Hunt

    Richard Hunt Member

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    Reply: 1.1.1.1.1.1.1
    From: Richard Hunt


    Rolf,

    No problems with the logic driving your proposed structure but I would still be reluctant about claiming the full amt of LMI as a borrowing expense.

    The problem you have is that the law requires you to apportion the total LMI premium “incurred” as a result of “borrowing money” on the basis of the “use” to which that money is put. Accordingly, whenever you draw down borrowings that have a mixed private and income producing use (in this case your 90% refinance), you are inviting an apportionment under the law of any LMI incurred in respect of that borrowing.

    AVOIDING LMI APPORTIONMENT DILEMMA

    If you understand this principle then the only challenge for you is to structure the timing of borrowings so as to deny any prospect of an apportionment taking place. In other words, structure the draw down to ensure that the “liability to pay LMI” only crystallizes on a discrete draw down of funds which are wholly used for income producing purposes.

    STRUCTURE DISCRETE BORROWINGS TO CLAIM 100% DEDUCTION

    Using the example in your post, this is simply achieved by initially borrowing the 80% for the PPOR, followed by a separately negotiated 10% draw-down of funds, which would be used to finance the deposit on the investment property.

    I don’t think it matters whether the additional 10% is by way of separate loan contract with the lender or simply a “top-up”. What matters is that it is this discrete borrowing of money that "triggers" the liability to LMI. In addition, because the draw-down is wholly for income producing purposes, we eliminate any risk of the LMI being apportioned under the law.

    In this way your client obtains a 100% tax deduction for the full LMI premium, rather than the 1/9 apportionment offered under the alternatives suggested. This result is even sweeter given that the LMI premium itself is calculated by reference to the total of both the non-deductible (80%) and deductible (10%) borrowings.

    Run this past your client’s accountants and see how they like them apples. I’d be interested in any feedback they provide.

    Cheers
    Richard

    PS. As per Dale's remarks, max. 5 year w/o applies.
     
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  9. Waverlybay

    Waverlybay Member

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    Reply: 1.1.1.1.1.1.1.1
    From: Waverly Bay


    Interesting suggestion Richard - but is there still a risk that the ATO will "aggregate" the two separate loans (or to use your wording, one loan and one separately negotiated top up) as one "combined loan" and argue that the LMI costs relate to the "combined loan". Will the mere use of two separate loan/lending instruments/separately negotiated top up ..be sufficent for linking the entire lmi costs to the "income producing loan"?

    One side point.... as has been previously mentioned, if the LVR drops to say 80% (from 90%).. within 12 months, then depending on the lending institution a refund of the LMI could well be available. The deductibility of the LMI (if available) in this situation would merely be a timing difference, and therefore i would have thought, to be a moot point. Naturally, the key consideration for the refund of the LMI would be whether the lvr can indeed drop to below 90% (or 85% depending on the lending institution) - which would again depend on the property purchased, whether it was purchased under market value at the outset etc..)


    cheers

    Waverly
     
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  10. Rolf Latham

    Rolf Latham Member

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    Reply: 1.1.1.1.1.1.1.2
    From: Rolf Latham


    Hi Richard

    This be a good point, thanks for that.

    I always insist on separate structures, never mixing PPOR with IP debt, so the 10 % for the IP deposit would always be in a separately drawn facility

    I think we are talking the same logic in different terms, I wasnt too clear on the split.

    In regard to tax agentsand accountants,
    understand there are some tax advisors out there that double as unlicensed financial advisors. It is not unusual for clients to tell me that their accountant has said to them that they should focus on paying off ALL their PPOR debt and then save a cash deposit + costs for purchasing an IP.

    While those conservative folk out there think that they would rather be safe than sorry, client experience has taught me that they are likely to be unsafe and sorry. Imagine the futility of saving for a deposit in a market like Sydney or Melbourne - where do these people come from ?

    ta

    Rolf
     
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  11. Richard Hunt

    Richard Hunt Member

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    Reply: 1.1.1.1.1.1.1.2.1
    From: Richard Hunt


    Hi Waverly,

    On your first point -

    Try not to rely too heavily on logic and common sense to anticipate the tax treatment of the LMI premium. I'd think we'd all agree with you that, using your words, "...the LMI costs relate to the combined loan". We could further justify this by pointing out that the LMI premium is calculated by reference to the combined total of the loan.

    Nevertheless the tests for deductibility are based on neither of these criteria. Instead the legislation prescribes two main criteria:

    1. establish what borrowing triggered a liability to pay LMI (in our example this is the discrete borrowing that takes the LVR past say 80%); and,

    2. what portion of this discrete borrowing is used for income producing purposes (in our example this is 100%).

    The only result possible under the legislation is that the full LMI premium is 100% tax deductible.

    On your second point -

    We had a thread running on the issue of LMI refunds a couple of weeks ago. Consensus was that the only time many lenders will refund LMI premium is when the borrower decides to refinance within 12 months. Even then many lenders will only refund a maximum of 40% of the premium.

    On this basis the full LMI premium, or a majority of it, will always be a permanent difference and remain deductible.

    Have i convinced you?

    Cheers
    Richard
     
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  12. Waverlybay

    Waverlybay Member

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    Reply: 1.1.1.1.1.1.1.2.1.1
    From: Waverly Bay


    Hi Richard

    The purpose of my post was to inquire about the risk factors of your proposed structure. You seem to be suggesting that the PPOR loan should be separate and distinct from the IP loan/top up/discrete borrowing ("IP Loan"), and that it is this latter IP loan which is the direct "trigger" for the LMI. ie the LMI expenses are incurred as a result of the IP loan, the proceeds of which are used for an income producing purpose.

    The relevant section of the tax legislation (section 25-25) allows a deduction for expenditure incurred by the taxpayer in borrowing money to the extent that the borrowed money is used for the purpose of producing assessable income. The "expenditure" in question is the LMI expenses which are passed on from the bank to the borrower.

    You have taken the view that the LMI expenses are incurred as a result of the IP loan, and as such are deductible under this section. My original post raised whether there is a risk of the ATO arguing that the LMI expenses are incurred as a result of BOTH borrowings from the taxpayer - one of which is used for the PPOR purchase and the other for the IP purchase.

    I believe there is still a real risk of this treatment from the ATO under your proposed structure. The legal form of your structure may indicate that it was the taking out of the IP loan which aroused the interest of the Mortgage Insurers to impose LMI. But the substance of your structure still very much points to the LMI being incurred by the taxpayer as a result of BOTH loans being taken out. The upshot would then be that the LMI costs would not be deductible to the extent that it was incurred by the taxpayer in borrowing money that is not used for incoming producing purposes (ie the PPOR loan). The Mortgage insurers do not impose the LMI by looking at the IP loan in isolation. The Mortgage Insurers look at both the PPOR AND the IP Loan, work out a LVR based on the value of the underlying security - and then impose Mortgage Insurance accordingly.

    Substance over form is alive and kicking - and the ATO love it. I work in tax structured finance which seeks to capture tax arbitrage or tax advantages in transactions such as cross border leases, securitisation, tax sparing, tax effective derivative and foreign tax credit utilisation structures. I have also worked on tier 1 deals which currently is a hot issue on the ATO books (known in Australia as "Income Securities"). In all our deals, enormous work is spent setting up the right legal form of the transaction to create the desired tax outcome. But increasingly the key concern of the ATO and other revenue offices in Europe, Asia and the US.... is whether the substance of the transaction gives proper and commercial effect to the legal form (read the current Income securities rulings and you will see this vigilance at work). It is against this background that I raised the risk in the original post - perhaps i have become a tax party pooper as a result !

    As for your refund LMI point - i am aware of 2 investors who got a full refund. I know others who got more than a 40%. Admittedly, these cases were last year, and if the policy of ALL the Mortgage Insurers have now moved to an inflexible, can-only-do-40%-refund, then i am happy to defer to your experience, given that you are in the broking industry. I am aware of the ANZ bulletin that was circulated in august to the brokers which explained the 40% refund cap... but have all banks moved to this position...and is it set in stone. No idea.

    Richard, you do not need to convince me of your structure. It is the ATO that ultimately needs to be satisfied of your argument. Like most people on this forum no doubt, I have enjoyed your posts so far. I have worked with good tax advisers and lawyers and it seems that you have been in the game for a while -which is fantastic for the forum.

    For someone who has never paid LMI and does not have a vested interest in the outcome of this post- i feel i have said w a y too much !

    Cheers
    Waverly
     
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  13. Richard Hunt

    Richard Hunt Member

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    Reply: 1.1.1.1.1.1.1.2.1.1.1
    From: Richard Hunt


    Waverly,

    I’m always interested in alternative views.

    I acknowledge concept of “form vs substance” and its potential application across a wide variety of transactions, particularly those transactions to which to refer, where ATO suspicions are likely to be instinctively heightened (rightly or wrongly) by a combination of factors including the sophistication of the taxpayer, the complexity of the transaction and the potential impact on tax collections.

    Never be concerned about saying too much, it’s one of the reasons why we have such a healthy forum.

    Regards
    Richard
     
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