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Tax Tip 131: Breaking a Fixed Loan – 3 Different Tax Consequences

Discussion in 'Accounting & Tax' started by Terry_w, 30th May, 2016.

  1. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Breaking a Fixed Loan – 3 Different Tax Consequences

    Comments by RobG in another thread, Tax Tip 130: Tax Deductibility of Breaking a Fixed loan on Owner Occupied, have lead me to consider break costs with fixed loans more closely.

    There are a few different tax outcomes with breaking a fixed loan depending on when, how and why a loan is being broken.
    Break costs could be either:
    • Capital Costs
    • General Deductions
    • Discharge costs


    Examples
    1. Capital Costs
    Jim starts up “Jims Hairdressing” and plans to franchise it. He borrows $100,000 from DEF Bank at 5% and fixes it for 5 years and uses it for shop fitout. The business fails and rates drop. Jim decides to close the shop sell what he can of the fit out and repay the loan. His bank charges him a $5000 break fee for repaying the fixed loan early.

    This is a capital cost and Jim cannot claim any of it. It may form part of the cost base of the business and result in him declaring a bigger loss, but he cannot use it to offset his other income as a plumber.

    2. General Deduction
    Bart buys a rental property and borrows from DEF Bank and fixes at 5% for 5 years. After a year into the loan rates have dropped and DEF are advertising 3.99% fixed for 3 years. Bart decides it is worth his while to pay the $5,000 break fee so that he can save 1.01% for the next 4 years. This should be deductible because it is a general expense relating to an investment (s 8-1 ITAA97)

    3. Mortgage Discharge
    Bart then decides to sell that property and to do this he needs to discharge the mortgage and pay out the loan. This means he incurs another $5,000 in break costs for the fixed loan. But this time the circumstances are different. This is not a general investment cost because it is a cost relating to the discharge of the mortgage and it is deductible because of s 25-30
     
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  2. Paul@PFI

    Paul@PFI Tax Accounting + SMSF Business Member

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    Change in the use of the property can also affect deductibility. In example 2 if Bart decided that he wanted to live in the property and also use a chunk of cash in his offset to pay that loan down and leave it as variable it would trigger a break cost.

    Important that the breakcost relates to the investment. Timing of when the breakcost is incurred is critical.Must be done while tenanted. How soon before ?? 1 day, 1 week, 1 month, several months ??
     
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  3. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Yes I agree there is no certainty
    See Tax Tip 29: Timing the breaking of fixed loans
     
  4. Paul@PFI

    Paul@PFI Tax Accounting + SMSF Business Member

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    I think Rob described it well as :
    I would caution that this ruling (TR 93/7) in in respect of an ongoing rental arrangement.
     
  5. Dwalsh

    Dwalsh Well-Known Member

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    Hi Terry I have recently broken an investment loan and refinanced it to another bank. Would these break costs be a capital cost or a deduction with in that year ?
     
  6. shelleykins

    shelleykins Well-Known Member

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    Thanks Terry. Another thing I found is that the break fees can vary by thousands of dollars over any given day. I broke my 240k fixed loan with cba and I called every day for about 3 weeks to check the break cost for that day. Quotes were as high as 3.5k but I broke at 1.5k. If you know it is something you want to do and have a little time up your sleeve I would definitely recommend calling in advance - a 3 minute phone call each day can literally save thousands of dollars.
     
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  7. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Sounds like example 2 to me. It would probably be deductible in the year it is incurred.
     
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  8. Dwalsh

    Dwalsh Well-Known Member

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    Thanks Terry !
     
  9. Paul@PFI

    Paul@PFI Tax Accounting + SMSF Business Member

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    I worked in financial markets and the whole process is complex. The bank will generally base its break cost rate on the bank bill swap rate for the same period to expiry with a margin applied equivalent to the home loan margin v's ""BBSW"" market rate on the day. BBSW refers to the Reuters indicator bank bill swap rate (BBSW) set each day. However this margin isnt always a good correlation to mortgage interest rates for the same period especially where the loan looks to expire within a year. They will often inflate the short term margins AND base the break cost on current branch lending rates...You know honeymoon rates - They can use that and apply a margin...Ouch. Its often far lower than the "market" rate should be. The lender will also adjust the calculated amount for the present value of a dollar v's a future value.

    The longer the term and the broader the margin between the original rate and the present rate the more it costs and each 0.10% can be significant v's a short term payout etc which may be somewhat trivial. Dont hesitate to ask the lender what the break cost rate is and how it was determined. It is an area where some negotiation can sometimes work....Especially if you remain with the same lender on a variable rate for example.

    At the end of the day if the fixed rate is higher than the variable then under most fixed rate agreements then you owe the bank. Once upon a time banks would pay the customer if a break cost was in favour of the customer. I say once upon a time. Banks like Westpac dropped that and instead allow customers to repay a limited amount per annum without a break cost ($25K ??)

    I agree shop the banks own pricing carefully and negotiate it too.
     
  10. shelleykins

    shelleykins Well-Known Member

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    Thanks Paul. I wish I'd known about the negotiation tip before hand! Very helpful info though :)
     
  11. Dwalsh

    Dwalsh Well-Known Member

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    H
    hi Terry, I just asked my accountant about these break fees being deductable in the financial year and he said no it is a capital cost. Now I am abit confused on what to do. It was an investment loan that I broke the fixed period and then refinanced to another bank. All for investment purposes
     
  12. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Firstly ask him why, and to back up his answer with legislation or ATO authority such as a tax ruling.

    Then tell him it relates to the ongoing production of income so should be deductible under s8-1 ITAA 1997.

    If he resists, tie him up, and read to him

    of
    TR 93/7
    Legal database - View: Rulings: TR 93/7

    Point out that this is old and s51 is equivalent to s8-1 of the new act.
     
  13. SouthBoy

    SouthBoy Well-Known Member

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    @Terry_w, I happen to break a fixed margin loan after 10 months which was meant to run for 12 month. I had prepaid the interest for the 12 months and claimed tax deductions the previous tax year. When I broke the fixed loan the bank 'paid me' the additional interest I had paid 10 months ago for the previous tax year. How do I reconcile the extra tax deductions I had claimed the previous year?
     
  14. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    I don't know the answer to this - best to ask your tax agent.

    You would probably need to amend the earlier tax return as you have been reimbursed for an expense claimed. @Paul@PFI might know.
     
  15. legallyblonde

    legallyblonde Well-Known Member

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    Tax time again! Thanks again for your amazing tax tips @Terry_w ... There are a great starting point for getting your head around tax issues!
     
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  16. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    @Dwalsh - did you talk your accountant around?
     
  17. Paul@PFI

    Paul@PFI Tax Accounting + SMSF Business Member

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    Confused...No. Second opinion time. Not all decisions are correct.

    With respect to the interest breakcost lets walk that through. You took out a 12mth prepaid and claimed the deductible in the prior year. So in the current year you should have $0 deductible unless the prepaid is repeated. But you broke the loan to pay it out with a new lender refinance. So in the present year the bank broke it and imposed a penalty (break cost).You then refinanced the same $ with a new lender.

    I would imagine that in the present year you have a deductible break cost. If the bank reversed out the prior fixed rate its likely a clause allowed them to retrospectively reverse that out and impose the new variable and a penalty. They didnt back date it so the transaction is a current year cost. So I would consider the debit interest is deductible and reduced by the credits for reversed interest. ie the net is a deductible. I would need to see stmts to confirm this understanding. No cause to amend the prior year. I dont agree on the capital cost. The break cost has a revenue nature if the IP is planned to be retained as a IP, just a new lender refinance.

    Realistically in such a refinance then your total current year deduction for interest if the new lender is not prepaid would be sum of all interest should be $0 with a payout / breakcost making it slightly deductible.

    + any remaining loan fees over the 60mths (5yrs) would become deductible
    + any new borrowing costs may have a new 60mth term for deductions
     
  18. Dwalsh

    Dwalsh Well-Known Member

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    Hi t
    hi Terry I will bring this up with him as I thought it would be deductable as well, don't know why he is saying its a capital cost. I will let him know today, thanks again
     
  19. Dwalsh

    Dwalsh Well-Known Member

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    Thanks for the advice, I will take this up with him today. And let you know what happened. Thanks