Tax Tip 290: Tax Deductions When Prepaying Interest

If interest on a loan is deductible it is possible to prepay up to 12 months of interest and to claim a deduction in the year that the interest is incurred – which will be the time of payment.

A maximum of 12 months applies because of s82KZM of ITAA36.

Note that you cannot just pay 12 months’ worth of loan interest but will need to ask your lender to charge you the interest in advance. Depositing 12 months’ worth of payments in an ordinary loan will result in the principal of the loan being reduced but no interest incurred. And therefore no deduction available.

Why would someone want to pay interest in advance? Generally, because of a high income this year and an expected low income next year.


Example

Homer is about to retire. He finished work in July so next year his income will drop as he won’t have a wage – he will live on offset money for 6 years and then start selling up his properties. He still has a number of loans though and to maximise his deductions he prepays the interest on 5 loans creating an extra $100,000 tax deduction in the year before he finished work. He would save about $37,000 in tax doing this. Next year his tax on the rental income might be just $20,000 so he has a saving of $17,000 overall.

The following year he will have no interest to claim but his taxable income will still be much lower than this year because of not having a wage.


See

s82KZM of ITAA36
INCOME TAX ASSESSMENT ACT 1936 - SECT 82KZM Expenditure by small business entities and individuals incurring non-business expenditure

 

Terry,

Does there need to be another plausible reason why you are doing this other than savings tax? Ie. The interest rate is discounted for prepaying the interest?

Regards,

Jason

 

Hi Jason, no not really. The idea is that the ATO might think the only reason to do it is for a tax advantage, but all lenders would give a slightly better rate for paying in advance so I don't think it would matter too much - except perhaps with related party loans.

 

@Terry_w Thanks for this scenario, very interesting.

2 separate questions:

You've asked the bank to charge you for 12 months in advance, and made that payment, what effect would:

a) you have a variable rate loan, and during the subsequent 12 months that rate drops?

or

b) you were to sell the asset and retire the loan within that 12 months?

 

You need to fix the loan to be able to pay in advance. 1 year fixed. If you break you would get back part of the interest less the break fees.

 

If you are wanting to prepay loan interest its too late for almost every lender. I have noted many clients who can achieve a similiar outcome by breaking a fixed rate loan. This will trigger a break cost now and this would be deductible with lower interesat each month for the remaining term.

 

I recall once getting a request on the 28th of june.

 

Slight tangent: how far in advance (financial years) can one pre-pay investment expenses, eg strata levy, and claim in the current tax year?

 

same legislation applies so 12 months. But you must have 'incurred' them which basically means you must have been invoiced.

 

Cheers @Terry_w , much appreciated.

 

And some strata costs may not even be deductible. I often see people facing a large special levy for capital works "repairs". The works must be completed to trigger the deducibility or capital allowances and not just paid. By far the easist prepayment costs are :
1. Prepaid loan interest
2. Break costs on a fixed rate loan
3. Refinance which triggers balance of LMI and borrowing expenses to become immediately deductible.
4. Bring forward deductible repairs

Prepaying expenses which arent borrowed are often ineffective for cashflow purposes. eg You spend $10K on repairs this may increase tax refund by $3300 so the net cashflow is negative $6700.

 

Thanks @Paul@PFI , #4 is high on the list.

 

Thanks for the idea. I have fixed @4.15% and another 10months to go. And was thinking to move out. But not sure whether banks will be able proceed before EOFY.

 

Breaking a fixed loan should be able to be quickly done.

 

If one were to prepay interest on an IP loan and then move into the property a month later, would the full amount of the prepayment be deductible?

 

No

 

Thanks, Terry! Would the prepayment have to be considered separately for the purposes of apportionment or can it be lumped together with the rest of interest costs?
E.g. interest is prepaid on 31 Dec and the property is only available for rent between 1 July and 31 Jan, would 1/12 of the prepayment be deductable or 7/12?

Also is there a clawback of the deduction claimed if the use changes in the following tax year? E.g. interest is prepaid in June and fully claimed. The owner's circumstances change and he moves in in September.

BTW thanks for sharing the knowledge in the Tips, it's a great series and has been a great read!

 

I think it would need to be worked out on a daily basis

 

If interest is prepaid and the use later changes an amendment may be required. Unusual to do a interest prepayment at 31 December and would have the purpose for doing this. I have only ever seen it at June so the effective deductible is doubled in Year one. If not repeated in year two the deduction in year 2 is $0. Its a warning I always like to remind people about. For people with windfall income in year one this can help smooth the tax "hump".

 

Thanks, Paul and Terry. The primary purpose would be to reduce tax which can be a problem in itself.

The scenario I was going for is:

• you have a property that you want to move into, but the fixed lease does not expire until Jan 31
• assuming $500k loan at 3%, the annual interest cost is $15,000,of which $8,811 will be deductible (215/366 days)
• instead of paying interest when it is due, you prepay 1 year of interest on 31 Dec while the property is still tenanted - prepayment of $15,000
• total interest paid in the year is now $500k x 3% x 184/366 (until 31 Dec) + $15,000 (prepayment) = $22,541
• you claim $22,541 x 215/366 days = $13,241 (instead of $8,811 above)

The EOFY bank statement will probably show the full amount $22,541 as "Total interest paid this financial year" without specifying how much of it actually relates to the current financial year, and presumably this will also be the figure provided by the bank to the ATO.

This is probably rather aggressive and either the prepayment has to be considered separately for the purpose of apportionment (i.e. can't just take 215/366 of it), or it may be disallowed as a tax scheme.