Tax Tip 294: Are Fixed Loan Break Fees Borrowing Expenses or Mortgage Discharge expenses?

Example

Homer is with bank ABC for an investment loan and has a 2 year fixed rate on 4.5% interest. Variable rates are much lower so if he breaks the loan he can get a lower rate. Unfortunately, Homer cannot refinance, due to servicing difficulties, so has no choice but to stay put and break the loan (or keep it fixed).

He breaks the loan and it reverts back to variable and he incurs a $1,000 break cost.


What is this fee?

· Is it a borrowing cost, s 25-25 ITAA97, or

· Is it a discharge of mortgage cost 25-30 ITAA97?


Note that the mortgage has remained in place as Homer never changed banks and it was never discharged. It is just the loan that is varied.


Mortgage discharge costs are deductible in the year they are incurred and borrowing costs are deductible over 5 years or the life of the loan if it is shorter. Therefore, the characterisation of this could be important as it may determine whether the cost is deductible in full this year or over the next 5 years.


The ATO calls break costs such as these ‘penalty interest’ and in TR 2019/2 analyse when penalty interest might be deductible.

They say penalty interest is not deductible under s25-25 as it is not incurred for borrowing money -i.e. it doesn’t relate to borrowing money because the loan is already in existence. This makes sense to me.

Penalty interest incurred to discharge a mortgage is deductible to the extent that the mortgage related to loan moneys that were used for producing assessable income. This also makes sense.


Unfortunately, there are 3 examples give and none of them relate to our situation of not discharging a mortgage but incurring penalty interest.


So are the break costs in relation to investment loan deductible?

The ATO considers they would not deductible under s25-25 ITAA97

It is unclear whether they would be deductible under s25-30 ITAA where there is no refinancing of the loan from one lender to another and the mortgage is not discharged. Even if we conflate ‘mortgage’ with ‘loan’ there is still no ‘discharge’.


Seek specific tax advice.

 

Have to agree poor old Homer may have a issue BUT it could still be deductible.

The reason : penalty interest is not deductible under s 25-25 (borrowing expenses) as it is not incurred for borrowing money. It is incurred for the complete opposite. However as that doesnt mean its NOT deductible as two other provisions are available:

Broadly, the ATO’s view is that penalty interest may be deductible in certain circumstances under the following two key sections :

• It is generally deductible under s 8-1 (general deductions) where the borrowings are used for gaining or producing assessable income or in a business carried on for that purpose, and it is incurred to rid the taxpayer of a recurring interest liability that would itself have been deductible if incurred. However, it is not deductible under s 8-1 to the extent that it is a loss or outgoing of capital, or of a capital, private or domestic nature.
• It is deductible under s 25-30 (expenses of discharging a mortgage) to the extent that the loan moneys were used for producing assessable income. Note that, unlike s 8-1, deductibility is not affected by whether the expenditure is capital or revenue in nature. (Note s25-30 in a inverse view and refers to the original borrowing purpose and not a new one being refinanced)

The taxpayer can choose which provision operates. More likely a concern if the owner is a smsf and it has exempt income.

 

Yes prob s8-1 could be most appropriate. I don't think it could be deductible under s25-30 but the ATO may have other ideas.

 

CCH think it can : I quoted them

It is deductible under s 25-30 (expenses of discharging a mortgage) to the extent that the loan moneys were used for producing assessable income. Note that, unlike s 8-1, deductibility is not affected by whether the expenditure is capital or revenue in nature.

As a discharge expense it looks back to the original loan rather than the present events ie discharge. ie why I added the inverse view comment. I beive in Homers case its deductible under both. But if Homer had punted the tenant and it was vacant it still would be deductible under both. I'm thinking of an example where s25-30 would work but s8-1 fails... Thinking

OK here is one dont sue.

Homer buys a IP and rents it several years. Then looks to break loan but moves to live. That arvo he transfers $$$ from his offset and breaks the loan. Bank charges break cost. s8-1 says the break cost is non-D as its private and clso capital in nature (i think). s25-30 allows a dedution based on time apportionment. Its related to arguements raised in Steele's decision concerning when a cost is incurred and timing. s8-1 isnt kind to that but s25 is.

Mike would likely have a good view. He is good with the little stuff and can rattle off cases.

 

Thanks for the informative thread
I recently moved my IP loan to another bank. and had to pay around $500 in various bank discharge fees
does this mean that I can have that $500 as a tax deduction this year?

the banks also charge a fix yearly fee on the investment loan apart from the interest
is that fee also deductible per year ?

 

TR 2019/2 Income tax: whether penalty interest is deductible

5. Penalty interest is generally deductible under section 8-1 where:

· the borrowings are used for gaining or producing assessable income or in a business carried on for that purpose, and
· it is incurred to rid the taxpayer of a recurring interest liability that would itself have been deductible if incurred.

Example 1

13. John can refinance his rental property at a lower interest rate. In order to refinance, John pays out the first loan early. He incurs penalty interest calculated on the basis of one month's interest for each year of the loan period remaining.

14. The advantage sought in practical terms by repaying the first loan early and incurring penalty interest is future interest savings from a lower interest rate. Penalty interest is of a revenue character and deductible under section 8-1.

15. Alternatively, where refinancing affects the discharge of a mortgage securing the first loan, the penalty interest is deductible under section 25-30.

 

That needs personal tax advice