An issue with mixed purpose loans where both portions are investment. Tax law time. Most readers will know the dangers of mixing loans – partial used for investment and partial for private purposes. But there is also a potential problem with mixing 2 or more investment purposes in the one loan account. An example of a problem with mixing loan purposes. Tom has a $500,000 investment loan which was used to buy 123 Smith St. Later he taps into the equity of this property and borrows another $400,000 also secured against 123 Smith St and he buys 456 Jones St. His broker tells him to take the $400,000 by just increasing the $500,000 loan to $900,000. “It’s all deductible after all”. The interest on the loan will be added once per month and comes in one amount so Tom needs to apportion it between Smith St and Jones St when he does his tax return. This is easy to do. Smith is 5/9 x the interest incurred and Jones is 4/9 x the interest incurred. Great Tom thinks I am saving $9 per month in account keeping fees by having 1 loan instead of 2. Later Tom sells Jones Street and receives a large sum of money. The $400,000 loan is not secured by Jones St so there is no compulsion to repay the loan. Tom thinks he can keep it open and still claim the interest – but he cannot because there is no income associated with that interest he incurs. So after seeking advice Tom decides he will use $400,000 cash to repay the loan. (doesn’t matter if he does this at settlement of after). Tom plunks $400,000 into the loan and thinks it is all done with. He has paid off the debt associated with the $400k borrowed to use as the deposit for Jones St. A year later he is audited and the ATO deny the claim on interest of the $500,000 loan. Why! Because the original loan is a mixed purpose loan. There are 2 sub loans in the one loan and they are no segregated. So when Tom deposits $400,000 it must come off the 2 portions of the loan in an amount related to their portion. $400,000 x 4/9 = $177,777 (i.e. the $400k loan is 4/9ths of the total $900k loan) $400,000 x 5/9= $222,222 $177,777 of the deposit will come off the $400,000 portion and $222,222 will come off the $500,000 portion. Imagine you have a bottle with milk and orange juice mixed. If you withdraw say 400ml you cannot choose to withdraw just milk as the solution is mixed. Same thing applies here. Going forward Tom will have a loan balance of $500,000 but will only be able to claim the interest on $277,778 of this loan. Tom’s desire to save $9 per month has cost him dearly. $222.222 x 5% =$11,111 in lost deductions each year. If he is on the 47% tax rate this would be approx. $5,222 in lost cash per year for the life he owns the property. Imagine if you have $5,222 extra you could use to pay off your non deductible home loan each year. Imagine the compounding effect.