Tax Tip 340: Borrowing When the Money will be Used by Someone Else

If person A borrows money but person B uses that money to invest then the interest will not be deductible. Person A derives no income from the borrowings so cannot claim the interest, Person B derives income but not interest.


The solution is relatively simple – person A borrows and onlends that money to person B. So person B incurs interest which they could then claim if they have borrowed to invest.


For this to work out the following, at least, will be needed:

a) A written loan agreement

b) Commercial terms

c) Rate that person A charges should be at least the same as the bank charges, if not more

d) Doesn’t necessarily need to be a secured loan


Example

Homer has a homer loan which is not deductible and wants to debt recycle but invest in the name of his wife Marge – who is agreeable.

What Homer would need to do is to split the loan and then redraw and onlend to Marge under a written agreement.

Homer is charged 2.59% on his loan and his agreement with Marge has the interest rate matched to the rate that Homer pays his bank.

Homer lends Marge $100,000 and charges $2590 in interest. Marge claims this as a deduction and Homer’s income jumps by $2590 but he can deduct the $2590 he pays the bank. Homer’s net income from this transaction is nil. Marge makes $5,000 from her investment so she deducts the interest paid to Homer from this and has $2,410 in profit. Marge is taxed on the $2,410 – on which she pays no tax as she is still below the tax free threshold.

Get some tax and legal advice before attempting this

 

How is the tenure of the loan factored into? Repay after X years?

 

that is up to the parties to negotiate.

 

Could person B also be a trust or company?

With the agreement and commercial terms, could Person A's interest still be deductible even if person B did not use funds for investment?

 

A trust is not an entity, it would depend who the trustee is. Can't be both borrower and lender. Could be a company.

If A lends to B on commercial terms they could potentially claim the interest. Not much point for B to pay interest that they couldn't claim tho

 

@Terry_w i read somewhere that the payments back to the Spouse A(onlending to B) need be on a regular basis as if they were to a bank e.g. monthly payments...

but spouse B can only pay back the interest when she receives dividends.

is that going to be a problem?

 

That is something you should take advice on.
It doesn't necessarily need regular repayments.
But there is no reason Spouse B needs to receive dividends before paying interest. if you borrowed from a bank would they wait?

 

I would not be confident that the arrangement is acceptable as a arms length loan term. Or in practice may depart from what was agreed in the written agreement and jeopardise the whole arrangement. Repayments limited to the other parties income sound insufficient. Next if the shares take a hit and the market corrects then what - The repaymnets stop or are reduced ? This also suggests a capitalising issue which may also be an additional concern. While there is a wide variety of issues that can affect a loan term and repayment a failure to consistently repay and account for interest and repayments may be signs of a risk for tax outcomes.

There is also a tax rule that affects the lender. A money lender likely accounts for interest at month end (or another periodic term) under the terms of the loan. However this may be received sometime later. Is the payment for the interest or for P&I or part ? Typically the lender willaccount for inteerst on a accrual basis as the agreement prescribes. The payer will typically deduct in the same manner when they incur the interest. (eg like all property investors do). So you may even produce some adverse or unusual deduction outcomes. Its why accounting for the loan must be maintained and consistent with what is agreed.

Many tax schemes are attacked by the ATO using these principles. The scheme seeks to change timing.

 

if spouse B invests in high growth ETFs and only deduct interest expenses from taxable income when declaring capital gains in their returns.

is that ok considering they might want to sell their shares in three years time? or can they deduct interest from income every year even if they receive no dividends.

 

If no expectations of income no deductions of interest

 

s8-1 of the ITAA97 specifically prescribes that a deduction is allowed to the extent that it is necessarily incurred in producing assessable income.

As the only element of expected income is a (future) CGT event then the interest forms a costbase element of that future event. It is an addition to the cost base of that asset so when disposed the interest reduces the profit. This may be worth 50% the deduction v dividend producing shares. Nothing is claiemd until disposed. The interest also needs to be apportiobned reasonably for the parcels being acquired and later disposed.

 

@Terry_w
CBA wont allow a transfer of more than 100k per day into spouse B account.
Spouse A plans to redraw 250k into B's brokerage account.

is it best to have splits Loan A: 100k Loan B: 100k Loan C: 50k?
or is it ok to redraw from 250k loan in the following order 100k 100k 50k?
Thanks in advance

 

That is something you should ask your tax advisor

 

You can exceed those limits in branch, in person.
There is no need to split for each drawn down if they on three consecutive days. Blending occurs whn different purpsoes occurs. Not multiple transactions for the same purpose.

 

the lawyer I spoke to was confused about a spouse loan agreement and quoted $2770. Is that reasonable?

 

Not really IMO. If they were confused they may not be someone to engage.
A word of warning - some online agreements may be less than desireable. Ideally one where the solicitor customises it is best used. Many are a fixed format agreement and lack some detail

 

We charge $990 for an unsecured loan agreement and have had a private ruling for a client with one that passed their scrutiny.

 

Thanks. Can I get in contact with your office for a request to set that up?

 

If Homer wants to claim the interest from the bank, wouldn't he need to be on-lending the money with the intent to turn a profit?

Eg. if the bank is charging him 2.59% he should be charging Marge 2.6% or more.
I thought that because his 'business'/income producing activity is lending money, if he set it up for a neutral/nil tax position, a deduction wouldn't be allowed.

 

Not necessary to make a profit according to 2 recent private rulings we have obtained. But get your own advice on that.