Tax Tip 389: Interest Deductibility and Names on Title

Deductibility of interest is a tricky topic. Interest is basically deductible if someone borrows to invest in something that is expected to pay income.


Some situations where names on title does not reflect who can claim the interest.


Partnership

A partnership agreement may provide that the partners share income in proportions other than their legal ownership.


A Trust

Trusts don’t exist as a legal entity, but they are treated as entities for tax purposes. So the trustee may have their name on title, but ‘the trust’ is the one that claims the interest.


Non-spouses

Brothers Jim and John own a property and have a large LOC. John uses this LOC to buy a property in his wife’s name. In this situation it is unlikely that anyone can claim the interest. Jim and John should onlend the borrowed money to the spouse who could then claim the interest if the borrowed funds are used to invest in income producing assets.


Spouses

Jim and Joan own a property together and have a large LOC. They use the LOC to pay for an investment property in Joan’s name. It is likely that Joan will be able to claim the interest in full.

See Tax Tip 79: Interest Deductibility for 1 on title 2 on loans

Tax Tip 79: Interest Deductibility for 1 on title 2 on loans


Joint Purchasers whether spouses or not

Jim and Joan keep their finances separate. They buy a $400,000 property together. Jim pays $200,000 cash. Joan needs to borrow, but because Jim is an owner he must go on the loan (he could have went guarantor). Joan pays the interest. It is likely that Joan will be able to claim the interest of this loan solely and in full.


Son and Mum

Son borrows 20% deposit from mum to fund the deposit on an investment property. He pays the interest on mum’s LOC from where the money came. Nobody can claim the interest in this situation – mum cannot because it doesn’t relate to her income and the son cannot because he doesn’t incur the interest.


If they had a written loan agreement on commercial terms then the son could claim the interest mum charges as it is incurred to invest. This interest will be income to mum and mum maybe able to offset this income with the interest she pays her bank.

 

Partnerships may have issues with loans. A partnership wont be the borrower. A partnership isnt a legal person and it cant legally own property as such or borrow. Title can be joint however to reflect the legal interest which is like a equitable or beneficial interest - ie each 50%. Each respective partner may be the borrower or they may do so jointly. Or just one of them who could settle their loan on their share and so could the other parner. This limits cross liability perhaps. A non joint borrowing may be deductible merely by that partner against their share of income IF able.

Trustees that dont borrow is a common problem. Eg Fred is a trustee Director for a disc trust as investor and he borrows personally using a LOC and the trustee co uses the funds to invest. Technically, the trustee has not incurred any interest. Fred has.However as Fred has no fixed entitlement to trust income he cant claim a deduction either. The solution is to onlend uisng a documented and settled loan agreement.

Property businesses will disregard legal title and all profits (after all interest) will be shared equally. Property partnerships are simple but complex legal / tax arrangements as they are typically undocumented and require SUBSTANTIAL property ownership and a substantial reliance on all of the property income by the parties. Spouses will struggle in general terms to have a property partnership BUT can. There is no specific measure but start with thinking at least 20+ income producing properties. Tax rulings are wise where family members have extensive property interests. Borrowing capacity and land tax tends to limit the practice these days and its then more evident with wealth people. A company is NOT a property business. That confuses entity and activity.

eg Fred wins powerball and buys seven properties in his name. Leverage is approx 30% on average. The properties owned by the kids (only) tend to have the high leverage to reduce taxable income. He also buys two each for his four children (minors). His wife also owns five. Then jointly they own 12. A total of 32 properties. Its possible that the whole family are considered to be in partnership. Each faces personal tax on their equal share and the interest deduction benefit for the kids is lost. While land tax is assessed to each owner in each state the overall income tax net income for all property income after interest may be shared equally by all 6 family members with the kids facing a punitive tax outcome. ​

 

@Terry_w, just preparing my records for my accountant. Is interest deductible for rental properties on the date is in incurred or the date it is paid? My new loan has interest charged on the 25th of each month, but it isn't paid until the 21st of the next month (no idea why). So will it be deducted on the 25th or the 21st of the next month?

 

That is strange. Interest accrues daily and it is charged monthly. On the day you pay it is when it would be incurred. Technically it is the point at which it is incurred that is the relevant date.

 

I disagree. The date that interest is added (debited) to a loan account is when it is incurred. It may accrued continually within the terms of the agreement and that of the lender but generally the indebtedness indicates the sum of the actual charge being lawfully due in the accounting for the loan. When you pay it may usually be completely irrelevant (credit to the loan). This issue came up in COVID when lenders gave holidays. They didnt ask anything be paid...The interest was capitalised and remained deductible. The usuall ATO view on capitalising didnt apply for the exceptional nature of the issue and that it was temporary.

Interest is almost always calculated and charged on the same date of the month in the following month ie an arrears basis since dates you pay etc all affect actual calcs so the calc can only be based on fact. . So if you draw down a loan on 21st June the months interest is charged on 21st July for the period spannning 21 June to 20 July and will be affected by the numbers of days and other factors eg a rate change or early payment. The date charged is the date used for tax purposes. In such cases there would be no deduction in the month of June.

This also comes up with prepaying a year of interest. The lender will debit a year of interest in June then in each future month the borrower repays but nothing else is charged.

I came across a interesting ATO view (baed on a High Court decision) the other day in a ruling. They consider that while a loan may have interest added that the loan and its interest remain seperately due sums and dont "merge". It has application to some unusual issues but isnt normally a concern except with capitalising. It means there are two loans...One for the principal balance and the second for the unpaid interest.

 

Yes the day it is added to the loan is when you 'pay' it and when it is incurred. Once it hits the account the borrower is liable for it.

 

Doesnt matter when you pay generally. Or who pays it. (Subject to capitalising oe related party non arms length loan issues)

Many tax schemes attempt to change timing difference by accrual v entitlement v payment etc. ATO attacks the legal entitlement basis usually. Like playing three card marley the ATO cant see the ball under any cup and just refuses to play

 

it is effectively 'paid' on the day it hits the loan account. It is a debt at that point by increasing the loan balance. Paying into the loan just reduces this balance.

 

Thanks for your help.