Tax Tip 379: Tax Issues When the Lender Puts Borrowed Money into the Wrong Account

When borrowing against existing property and getting extra ‘cash out’ there is a high chance that the lender will put that money into the wrong bank account. If the name of the bank starts with N, it will be a very high chance.

If the lender puts the money into an offset account with is attached to that split it came from and if the offset is empty, the borrower will be able to argue the borrowed money can be traced back to the loan and the interest be deductible if the money is used to invest in income producing assets.

However, if the lender puts the borrowed money into an offset account that contains other money it will be disastrous as if you subsequently used that money from the offset the interest will not be deductible – there might be an argument for some of it to be deductible though.


Example

Homer has an $800,000 home loan and refinances with another lender and borrows an additional $200,000 on top as a separate split like this:

Loan A $800,000 with his offset containing savings of $200,000, Offset A.

Loan B $200,000 with an empty offset account, Offset B.

Homer instructs the lender to place the $200,000 extra borrowed in the offset against the smaller split.

Settlement happens and Homer logs onto his new internet banking app for the first time.

Bloody hell he shouts as he sees offset A with a balance of $400,000 and Offset B with a balance of nil.

Homer talks to his broker who contacts the bank and tells them they stuffed up and have ruined Homer’s life because they put the money in the wrong account. The lender claims that they cannot reverse the transaction due to the strict anti-money laundering rules (bull crap!).

Homer has to pay $200,000 deposit on his new investment property purchase by 2pm. What should he do?


If he uses the cash from offset A, only half, at most, of the interest on the $200,000 will be deductible because the borrowed funds have mixed with the cash in the amounts of 50/50.

If he transfers $200,000 from offset A to offset B this doesn’t change anything and at most 50% would be deductible.

What he should do is to put $200,000 back into Loan B, without closing it, and redraw it out into offset B, and then pay the deposit. Then he can argue that the interest on the full $200,000 will be deductible.

 

There are a range of places I see where it can be deposited

1. To a new offset with $0 balance. Should be OK. HOWEVER, No other funds should also be credited to this account unless ALL the funds will later be fully used to acquire a single investment. The offset will be blended with the deductible interest element and "savings"but all will be deductible. Note that many lenders may prohibit a offset containing more funds that the laon it offsets. So e lenders will ignore the issue. No "tax benefit"of having a offset with more $$$ than the loon can exist.
2. A existing offset with $0 in it. This can still be a concern. Think of it this way. The existing offset may be linked to another loan. THAT loan interest will reduce. It may reduce a interest deduction ? Or be non-deductible. However the interest on the new loan will still be charged but not have any deductible purpose. Its not a loan refinance either. Best not to change loans linked through offsets without knowing the tax impact.
3. A savings account. A concern. Always. The later use of the funds is from savings and isnt borrowed money as that element is lost. Often blended too. The exception can be a savings account with NO OTHER BALANCE now or later that is then ALL used for a deductible purpose eg buy shares.
4. A different loan account with a redraw. A concern. That loan is now blended. Its a bad "refinance
5. ANOTHER PERSONS accounts. A likely problem. Seek personal tax advice. It may also affect deductions but the issue is one of "who"can deduct interest now. And can all of it be deducted ? Some exceptions apply for spouses and if they are also a co-borrower.
6. DEOSITED TO ANOTHER PERSON because you are onlending to them. eg Spouse etc. A related party loan agreement is likely needed.

One other option is to CHECK the new loan has a redraw facility AND the lenders allows you to repay 100% of the new advance so the new loan is $0.00 with a full ability to redraw when the correct time comes. Warning : Some, not all, lenders may autoclose the loan account. So elenders may leave it open if $1 balance remains. Ask twice before acting. Ideally get the reply from the lender in writing.

 

Getting the money into the right account is absolutely the best scenario.

I’ve often wondered, with all the great tips on contamination, why one couldn’t have a ledger system, in the same way real estate agents have property ledgers for a single trust account which neatly tracks whose money is whose, to show what money is for what purpose in a single account for when banks inevitably muck it up?

 

I guess it won't pass the urine test.

 

The ATO have a ruling on that view. They disagree and this is well supported by case law. As terry says its like extracting urine from a martini. You cant.

A trust account where someone acts as a trustee for OTHERS is different. eg real estate agents, solicitors and even accountants who operate a trust account for CLIENT monies. Their trust account exists by other law and professional practice to make ita regulated "product"...Just like a bank accounts for customer by customer funds. You cant be a trustee for yourself. The ATO ruling on LOCs is a suitable guide to the concerns. It guides that repayments for instance cannot be applied to a specific purpose. TR 2002/2 and is one of many guides to "blended loan"issues generally.

 

And banks certainly DO make mistakes!!!

Years and years ago when everyone had chequebooks, we ordered a new chequebook for our business (a company). The new chequebook arrived and we started writing cheques.

One day shortly after, we received a phone call from our bank advising us that our SMSF cash account was overdrawn. Impossible we thought.

On investigation, we determined that the bank had linked our business chequebook to our SMSF account, even though both entities had TOTALLY different names.

What a mess!!!

 

I don't disagree with the principal of this but there's a practial element to it as well.

Another analogy is that to achieve the required outcome you would need to be operating in a surgical theater, when you're actually working in the equivalent of a mechanics garage. It doesn't matter how careful you are, some contamination will occur.

Lender paperwork simply don't allow the level of detail needed to acheive the ideal outcome. In most cases the paperwork only allows one account to be nonimated for surplus funds so that's where everything goes. Even if they had more resolution there's often a level of ambiguity to the specific figures, when you consider things like payout figures only being known the day before a settlement.

The urine test is a nice analogy, but having worked on a dairy farm I can guarantee you that your milk does contain traces of bovine waste. All the attention to food handling won't eliminate it entirely.

 

Great, as I said something I’ve often wondered. Not only an answer but sound reasoning.

 

Any mistake can generally be rectified as outlined in my first post.

but there was one occasion when it could not have been fixed - I can't remember what that was now.

 

However is the trading company the trustee of the fund ? If so, that was a poor choice in setup ? The auditor should see this as a one off and a issue resolved but - Terrible it happened. IMO a trading company should never, ever be a SMSF trustee. The issue of keeping smsf assets seperate is demonstrated by the bank error

 

Usually when property has been settled after flowing through as blended or from savings etc Refinancing doesnt work. Resettling doesnt work.

 

No way. The other common words were “Pty Ltd”.

I couldn’t believe it. I can tell you the bank copped a severe blast from me.

 

Gross. But most food contains waste and other things. A drop of machinery grease here, a piece of plastic, a bolt here or there. Vermin. Usually dead. Sometimes in the raw materials and soemtimes in the factory. Human hair. Even that watery crap from production that they ADD back to milk is sus....Whey....Or as they would like it called "Permeate". Sure it comes from milk but its green watery crap. And added back it dilutes milk. And then they homogonise it to hide it.

Most food production is monitored for the composition of external elements. Hey China added melanine to its stock feed back in the early 2000's. Britain added tainted feed stock (cattele and cows fed cattle waste meat) to create a mad cow concern. Chicken feed is supposed to have a "no chicken" rule but any poultry farmer will tell you they will quickly eat a dead companion.

 

A trustee can have a name Pty Ltd and still act in more than one capacity...Imagine the company name was Sample (SMSF) Pty Ltd. And its only acted as trustee. It may be more evident. I generally suggest a smsf trustee use the word "smsf" in its name as a safeguard so its bleeding obvious. And for a bare trustee co "custodian" helps. The word "trust"or "trustee" are prohibited from name use however.

 

What about fixing a bank error going the other way? mine has taken the whole balance from my offset account to pay off a chunk of my investment loan without proper authorisation. I'm trying to get them to reverse it with words like ERROR REVERSAL. I'm hoping that will be enough for ATO to consider it as the same loan and not a new redraw.

I can see the funds are available in redraw and if the bank doesn't reverse it in a timely manner I wonder whether I would be justified to reverse the exact same amount back to the account it came from described as error correction and not have it treated as a new redraw? Getting a little stressed as I need to make payments to my other loans and they left $0.




Full story:

I by admission had a messy mixed purpose loan for a long time. Fully paid off PPOR except $0.01 then I drew deposits & expenses relating to four other investments out of the facility over a period of about 3 years. At the time I thought 'it's all deductible purposes so it's fine' and having it combined saved enough bank fees to be worth the little hassle at tax time and just kept meticulous records of amounts for each property (helps that it was a 10 year IO loan back so after being fully drawn there were no other principal deposits or redraws in the last 7 years, and it was fully offset at times as well)

So now, I'm selling the old-PPOR that is the security for this hot mess. I've been going to great lengths to get the bank to not pay off the loan since each piece of it will still be deductible going forward. Tried to substitute security but they wouldn't do it, so now I'm refinancing to another bank and setting up my four splits during that process. I want to preserve this so that I have the cash from the sale of old-PPOR available to buy a new PPOR instead of reborrowing non-deductible debt.

The loan application has been a hassle getting exceptional approval to use TDs as security until settling on new PPOR, exceptions for NRAS income, small business structure review and every senior credit assessor at this small lender being sick with COVID for the same few days, but it was coming together and aiming to fund next Monday before the sale settlement next Thursday.
Until this morning I got a text that a direct debit was dishonoured due to insufficient funds in the offset account of the one that will be closed next week. Turns out that two days ago, a full 9 days before the sale settlement, they have moved the full balances of the offset accounts into the loans and apparently their normal practice is to just provide a payout figure for the difference. On the discharge form I signed it said they would do that on the day of settlement, so I thought I had time to move the money before then.

I was keeping the offset money there to save some interest until new bank is ready to fund and they will open new offset accounts, and also needed it still in the old account to cover a few direct debits that I was going to change after finding out the new account numbers with new bank.
Called four people about it today. 2 couldn't help. 2 haven't called me back yet.
I'm sure I've got a good case to get it reversed but I'm worrying they won't do it in time before the refinancing bank requests a payout figure on Monday.

/rant

 

It is unlikely the lender will reverse it - they will cite anti-money laundering legislation as a poor excuse.

It is also likely that the terms of the loan agreement you entered into with them will allow for them to use your offset money to pay off you debts, without any further permission.

I would try to get them to reverse it and make a complaint to AFCA and then get some tax advice on whether you should apply for a private ruling to as the tax commissioner to disregard the loan being paid out - it could result in 30 years of lost tax deductions.

 

The bank will have a dispute process team. Act quickly. Its important to explain they have affected tax deductibility through their actions and you would consider damages based on this if a AFCA complaint progresses. Ask they reverse their accounting. If they must clear a linked offset seek the compromise that they transfer offset funds to a NEW CLEAR bank account at the very least. When the new offset is created they/you can revert to the new offset. I have had cleints with this issue resolved HOWEVER it can be slow and the settlement could be a problem that sets the issue in stone.

The ATO will not disregard practical events. If a loan is discharged that is what has occurred. A private ruling would be adverse. If the ruling relates to the temporary move from offset to savings to offset as above it is more likely to be favourable as a setting aside of the borrowed funds.

 

There is at least one private ruling where the ATO agreed to ignore a deposit into a loan and its subsequent withdrawal due to the fat finger argument of the taxpayer

 

Thats different to a bank discharging a loan under a signed agreement on its own commercial basis and then resettling. A indication each taxpayer should seek their own advice.

The ATO does tend to side with taxpayers when a issue is a error and immediately reversed...ie "fat fingers". However without a ruling it leaves the issue open.

I once had a client "park" a signiicant sum into a loan when they should have used the offset. Took over a month before taxpayer realised. Instead of putting funds back to the offset he drew it out for a new use. ATO disagreed it was a mistake. A mistake would have been been promptly corrected they said. And the new borrowing was literally that and so it didnt correct the mistake either. The new borrowing was for a non-deductible purpose and deductions thereafter were lost for the original investment use. Ironic - He was a solicitor.

 

Yes it could be a long shot but might be worth a try.