Tax Tip 16: Capitalising Interest

Likely to be seen as a scheme to increase tax deductions for the husband.

 

Let’s say you are on an interest only loan. You go to bank to rollover IO term for another 5 years, and they say NO, our policy has changed, it now must be P&I. So, to manage cashflow, you convert one of your loans to LOC and capitalise interest to manage cashflow.

 

It depends why the person is doing this. Is it to divert funds to the payment of non-deductible debt, is it to increase deductions for the spouse on the higher income and reduce deductions for the lower income etc

Where the spouses keep their finances separate and there is no non-deductible debt it might be fine.

The alternative is to borrow to pay the principal of the loan.

Tax Tip 46: Want to Pay IO on a PI loan? Tax Tip 46: Want to Pay IO on a PI loan?

 

Hi Terry, not sure if it is related. if X borrows $400k to buy an IP which the interest ($40k) is capitalised into the loan, it is a short term loan and due in one year.

X refinance in a year and got $440k to repay the short term loan, does the interest of the $440k loan deductible? Or only $400k is deductible since $40k is to repay the capitalised interest?

And is the capitalised interest ($40k) deductible?

Thank you.

 

This is covered in the opening post. Interest on interest is deductible if the underlying interest is deductible. But the ATO can deny the deduction if it is a scheme with a dominant purpose of increasing a tax deduction.

 

Anyone capitalising interest on loans used to buy shares? The ATO ruling only covers property.

 

TR 98/22 only considers the "loan account" and its interest deductibility with the tax benefit and capitalisation issues. The issue of use to acquire shares v property dont change this. Thats a interesting feature of how the ruling is drafted to address the loan itself. Its a good indicator of how the ATO views capitalisation yet the ruling appears limited to split loan facilities. Its not really. That ruling mentions "property" in the context of ownership and interests not real property

paras 30-32 are an interesting view that mentions the caselaw view from Bank of NSW v Brown (AKA Tom The Cheap) that interest on a borrowing and interest on interest are distinct amounts within a loan account. Interest doesnt merge into the loan.

 

I had TD 2008/27 in mind

 

Yes. I have borrowed for deferred purchase agreements, where 3 years interest and fees (20k) is borrowed for non recourse 100% loan for 100k of share exposure. 1k p/a interest for 3 years for an upfront 6k tax saving while getting a 70% return over the 3 years on the 100k of BRK and Dow Jones Property Index.

 

It is only possible to prepay and claim expenses up to 12months in advance.

 

a related thread
Loan Tip: How do You Pay One Loan With Another Loan? Loan Tip: How do You Pay One Loan With Another Loan?

 

Non recourse loans may mean no deduction is available in any event. Tax ruling be each of the lender and borrower should be considered.

 

Someone has asked me about capitalising interest where the borrower is a trustee or a company. It is possible to do, especially where the trust or company has no other income with which to pay the interest. I will write up a new tip on this.
The company or trust should seeks its own tax advice

 

There is a related tax issue to consider. A lender may be considered to be a money lender is such instances. This means that while interest may capitalise it may also be assessable to the trust as it is incurred by the nature of the progressive accrual of the trust income whether by way of the agreement and also the accounting for the agreements.

I encountered this issue with a client who thought they were being clever. For certainty we sought a ATO ruling on if the money lending provisions would apply. They said Yes.

In that instance the taxpayer who seeking to claim deductions and defer income tax. That also may give rise to Part IVA concerns where the mismatch between cash and accrual occurs. That is a further issue.

Many tax schemes operate on the basis of changing timing of accrual v cash.

 

In most cases interest would only be charged where imo ey I s being borrowed and onlent. Where cash is being lent generally it would be interest free. But not always

 

Hi Terry, Would the ATO view this scenario as acceptable?

200k IP loan
Redraw to 300k intending to buy IP
Pay the extra 100k back onto the loan used to cover the IO payment
Rental funds used to pay down PPOR debt
Use the remain money to purchase new IP after 1/2/3 years?

 

Not for deductibility. The loan may also be best split when it is ready to be used for a new IP to segregate the old loan and new amount

Would a offset be better to hold the new drawn funds until later use to avoid interest being charged and therefore capitalised? Splitting would be wise. Offset the new loan portion only

 

Have a read of the Hart case, it sounds very similar to that arrangement - but not the same.

What would the purpose be in implementing this 'scheme'?

 

Thanks I had a read through the case and it seems this wouldn't be acceptable.

What if you redrew 100k, put it in offset to pay the repayments and then used the extra cashflow to invest in income producing shares?

 

If you borrow and put the money in an offset you immediately have other issues to consider. See my tax tip 1.
But if you borrow to buy other income producing assets the interest could be deductible.
If you borrow to pay interest you are capitalising interest