Caplitalised interest on a refinance...

An interesting case came up today with the settlement of a refinance. I'm interested to hear the legal and tax perspective on this...

When a refinance occurs, the outgoing lender provides a payout figure to the new lender which is calculated to a specific date on which the settlement of the refinance will occur. Included in this payout figure is:
* Remaining principal to be paid.
* Fees from the outgoing lender such as break fees (if a fixed rate) and discharge fees.
* Interest incurred on the loan since the last scheduled repayment.

On top of this, the new lender will also charge various fees, which are usually being paid by the new loan being set up:
* Application & settlement fees.
* Government fees.

As a result, the new loan being set up is going to be a little higher than the original loan to cover the various costs involved. For an investment loan I don't imagine there's any questions about deductibility of the various fees being charged, but...

What about the interest incurred by the outgoing lender since the last payment? Wouldn't adding this to the payout figure be considered capitalising interest?

I'd suggest the interest accumulated since the last repayment should be charged to the borrowers nominated direct debit account. It shouldn't be capitalised onto the loan. When investigating this however, it appears that capitalising the interest to the payout figure is standard practice with every lender I've asked. Furthermore it's an automated process and alternate arrangements can't be made.

 

Yes it always happens like that. I don't think it is an issue as interest on interest is clearly deductible and this is only a one off event where the dominant purpose is not a tax advantage.

 

The problems I see with the banks doing this is:

a) it reduces the equity available to you from refinancing the loan because it reduces the redraw amount by the amount of the capitalised interest;

b) as a result of (a), if the purpose of re-fi is to use the equity for a deposit on another IP, you then may need to use some/more of your savings for the deposit; and

c) under a cash basis of accounting for tax purposes, the capitalised interest wouldn't be deductible as you haven’t paid/incurred anything (and as such inadvertently also increases your net taxable investment income for the year as you have less deductions to offset your rental income).

I don’t think this really is an ideal situation, the banks should be giving people the option to settle their interest from their linked account. It’s probably not such a big issue if the re-fi/new loan settles early in the month (as the accrued interest would be lower), but if the re-fi settles later in the month, you could potentially have almost a whole month of interest capitalised.

 

Hi Justine

Why do you think the interest is not incurred?

 

Hi Terry

My thoughts were that having not paid the interest you may not be able to claim it. I can't find any tax rulings on the topic though, so it was just my gut feel. Interested to know what others think. If the loan amount has increased as a result of the capitalisation, then technically the interest is now principal you owe.

However, the bank has applied that 'loan' to pay off your outstanding interest so maybe that is the argument to get you over the line for claiming the deduction.

Cheers
Justine

 

But you incurr the interest when it is charged - the borrower is legally obligated to pay the interest once it is charged to the account. It is like borrowing to pay LMI - you don't pay it but it is still incurred and can be claimed.

 

I agree it is similar and I think the right result.

The difference is that borrowing costs such as LMI, loan establishment fees etc have a specific legislative tax provision that enables you to deduct the cost over time because they are ordinarily capital in nature. And deductions for expenses in discharging a mortgage for an IP also has it's own specific legislative provision that allows deductions, but payments of interest are excluded under that section.

I think the argument is that the interest deduction is allowed because you did owe it at the time of re-financing, and you have technically paid for it (it's just that the bank has in effect loaned you the money to pay for it, and discharged the debt on your behalf with the loaned funds).

 

I see zero issues. There is a no "scheme" and parties are arms length and operating on commercial terms. This is the precise reason why some interest can be capitalised however ....where the loan is operated in a non-commercial manner on non-arms length terms the concern can arise. A good example is Dad lends to mum and interest compounds, there is no apparent repayment - Hence a sham "loan". Especially where Dad and Mum's arrangement shifts income to a low marginal rate v's a high marginal rate and a tax benefit is identified.

To address Justine's post - The interest would be incurred when the original lender adds to the account. Paid / incurred are different terms but you don't have to "Pay" to obtain a deduction. Where the taxpayer incurs it the cost meets tax law requirements. Tax rulings aren't issued for general matters of common law.

 

Harts case proved capitalised interest is tax deductible, the ATO would not have been able to argue Part IVA otherwise. All you have to be sure of is that the ATO can't argue Part IVA - dominant purpose of a tax benefit. As you say, standard practice not tax benefit

 

I believe you need to be a business member to advertise, Julia (Hartman?)