Capitalising Interest Capitalising interest happens if the interest on a loan is not paid when it is incurred but the loan is allowed to increase. The ATO generally refers to it as ‘compound interest’. “Compound interest is interest that accrues on interest that is unpaid” TD 2008/27 (para 7) The same rules for the deductibility of ordinary interest apply to capitalised interest. That is if the underlying interest is deductible then the interest on interest would be deductible. This was stated by Justice Hill on the High Court case of Hart a few years ago. It is also confirmed by the ATO in TD 2008/27 (paragraph 1). This is naturally attractive to investors as interest on investment properties will be deductible and if you borrow to pay the interest on the investment loans the interest on interest will be deductible too. This frees up cash which could be used to pay down the non deductible home loan sooner and builds extra deductions which could also assist with this too. But the ATO has the power to deny tax deductions (Part IVA) in certain situations such as where there is a scheme with a dominant purpose of increasing tax deductions. The ATO has published TD 2012/1 which states they can deny the deduction and that the reason of ‘paying off the home loan sooner’ is not a reason which would prevent them from denying the deduction. But there may be legitimate reasons where borrowing to pay interest may be necessary and where the interest may be deductible. The ATO even state “It is also acknowledged that compound interest, in some cases, will be deductible under 'ordinary' provisions. “ (in Ruling Compendium TD 2012/1EC) When might allowing interest to compound be ok? When the dominant purpose is not to obtain a tax benefit. The major one being: Cash flow A cash flow issue may be caused by loss of employment, maternity leave, Illness, unexpected debts, retirement It is essential that you obtain tax advice before doing anything like this.