Tax Tip 403: Borrowing 100% for an investment property using a Secured Div7A loan

Tax Tip 403: Borrowing 100% for an investment property using a Secured Div7A loan

In the 3 recent tax tips I have been talking about borrowing money from a related company – which could be a trading company, a holding company or a bucket company.

See:
Tax Tip 394: 25 Year Secured Loans from related Companies Tax Tip 394: 25 Year Secured Loans from related Companies

Tax Tip 395: LVR When Borrowing from a Related Company under a Secured Loan Tax Tip 395: LVR When Borrowing from a Related Company under a Secured Loan

Tax Tip 396: Borrowing from a Related Company and Second Mortgages Tax Tip 396: Borrowing from a Related Company and Second Mortgages


We have seen that it is possible to borrow from a related company over 7 years on a PI basis if the loan is unsecured. This short loan term makes for pretty high repayments, so an alternative is a 25 year loan, on PI, but this is only possible if the loan is secured by a registered mortgage and the LVR, for all loans secured against this property is 90% or less.

So how could someone borrow 100% for a property using a related party loan?


One way is to borrow 90% from the related company and the other 10% from a lender using a other non-company property as security.


Example

Homer has successfully debt recycled his entire main residence loan and has about $1mil in equity. He also controls a related company, which manufactures artificial legs, and this company has over $1mil in retained profits.

Homer sets up a trust to own property and he wants the trust to borrow 105% for each property.

What he does first is set up a loan facility so that he can borrow $1mil secured against his main residence.

He then uses this as the 10% deposit and 5% costs and borrows 90% from the company.

Each property that he buys has a 105% loan used to buy it, but only 90% of that is secured by a mortgage over the property that he is purchasing. The other 15% is secured by his main residence.

This enables Homer to buy property without getting a bank approval – after the initial ‘cash out’ is approved. $2mil worth of property with just $1mil in bank loan and $1mil in a related party loan.

This may even improve Homer’s borrowing capacity.

And Homer does not need to buy the properties in his own name. Some may be held by a trustee of a discretionary trust, some by himself as trustee for his son Bart, some owned by this wife etc.


The other way is to borrow 10% from the company as an unsecured loan and the remaining 90% from a bank type lender. These percentages can be varied too so that LMI can be avoided by borrowing 20% from the company and 80% from the bank.

 

Sometimes a dividend strategy can be used for the amounts above 90% if the company is cashed up. It does come at a tax shortfall cost for the shareholders but can be immediate equity. Boosts shareholder income. Dividend strategies that repeat are often considered as income by lenders and it can boost servicing capacity. Definately one for brokers to guide.

 

if for investment purposes as well the interest on the div 7a loan will also be deductible.

 

Yes. Of course one of the trade offs is the rate of 4.52% presently however this may be subject to low rates of company tax (25-30%) yet be net deductible at a high marginal personal rate which does produce a enhanced neg geared benefit overall possibly. The downside to personal borrowing is that any resulting cap gains etc also affect that taxpayer. Sometimes the borrower being a trust may shift potential future gains and even pos geared income to a broader range of beneficiary after interest eg a non-working spouse.

Another issue is the essential need to maintain correct and proper continual accounting for interest, repayments and the balance.

Such a loan could also fall outside Div 7A where it is lent for business working capital in some cases. (Specific advice of course).

 

But when you pay 'your' own company the interest is staying in the family group so does it really matter if the rate is high? The higher the rate the more deductions for the individual resulting in some tax arbitrage.

 

Leaving all things constant the higher rate is a disincentive BUT it can magnify neg gearing outcomes at a net tax saving of 47% less 25% = 22%. Yes it may be a mere internal "shuffle". That said in comaprision borrowing from a bank could be a net 47% saved at a lesser rate. Its not unlike a offset benefit being a reduction to non-deductible interest so it grosses up as a higher value.

Example
Borrow $100K as Div 7a v bank over 25 years.
Bank annual cost $2750 at 2.75%
Div 7A $4520 less 30% co tax = $1275 = Net $3245 which is 495 or 15% more costly. But that extra costs is also given a (up to) 47% benefit for the individual borrower in form of enhanced neg gearing. (4520-2750 = $831 extra refund) But it means this cost / benefit flows to the company for it to reinvest / relend etc. Perhaps recycled ?
Many Div 7A strategies can be recycled along lines of a line of credit.

 

also the minimum loan repayment required under div 7a which wouldnt be required with a bank loan. that dividend might well have top up tax.

 

But that can be a terrific deferral strategy. The dividend grosses up well for lenders too. Banks also charge interest from day one of a loan. Division 7A isnt the same. Easily overlooked.

Minimum interest rate
The interest rate of the loan for each year after the year in which the loan was made must be greater than or equal to the benchmark interest rate for each year.

 

Keep in mind that it might be possible to borrow to repay a Div7A loan and keep deductibility of Interest

 

Or discharge the loan and start a new one with the company acting as that refinancier. Line of credit style using amalgamated loan basis (with limits). Each years loan can be seperate where a bank LOC its a single blended facility. Div 7A loans can also be split into very distinct loans so purpose can be distringuished and kept apart. And unlike many banks can be for small or specific sums where many banks "have policies" that limit splits

I have always wondered can a company loan also have a offset ? One for the lawyers out there - Could it just be as simple as nobody has drafted the D7A agreement that way ? It could even be a factor never considered in the ATO views for Div 7A complying requrements. ?

 

I don't think a company could have an offset because if X owes Y $100 and X gives $10 to Y to hold it would really be a repayment of the loan. Offsets work with banks because they are deposit taking institutions and can separately contract a borrowing and a deposit.

It might be worth a shot with a private ruling though to see if the ATO would accept it for tax reasons. It would be handy with onlending agreements.

 

CBA/ WBC are also companies. Admittedly with banking licenses. But other companies can accept monies, and lend. I dont believe a company can take deposits from the pubic due to prospectus issues. But related parties certainly can have funds loaned to a company and also a borrowing from.

 

But if I lend you $100 and then you hand me $20 and say hold this, do you owe me $80 or $100?

 

agree a tax deferral strategy is definitely worth considering.

 

Div7A contains a requirement concerning interest rate that the MINIMUM rate must be equal to the ATO rate which varies from time to time. In instances when a borrower is seeking deductibility there may even be reason to consider a rate that is higher than the D7A minimum. The agreement may need to have a benchmark assigned eg A rate that is 0.40% above that of the Division 7A benchmark rate from time to time.

Warning - using a rate that is very high may fail general tax principles and Part IVA could apply to cancel a tax benefit. Care should be taken to set a rate is reflective of the competitive risk. I would arge a comparable rate could be determined by a PRIVATE mortgage. This may be a rate in the range of over 5% and up to even 7%. Specific advice and records should be maintained. Then the loan should be maintained on this basis. Loan arbitrage is a common feature to some tax schemes so care must be taken.

This would mean a higher deduction for the investor. And a higher assessable amount for the company. The net benefit should consider the investor marginal tax rate LESS that of the company rate. In addition the borrower should consider maximising the loan. Eg in the best case the tax benefit could be 47% less 25% = 22%.

This loan is limited to be no more than 90.90% of the market value of the property. The rule is that the market value should be no more than 110% of the loan amount. This is commonly mistaken to be 90%. But thats not quite correct. Using simple maths that mean 100/110 = 90.9090% is the maximum loan. So if the property cost $300,000 the maximum division 7A loan can be $272,727

 

Found some guidance on ATO page QC17341 which seems to take the view a offset account isnt permitted as Div7A applies to the loan account alone. More research....

Each entry in a shareholder's or beneficiary's loan account needs to be analysed to determine what type of transaction it represents (that is, whether it is a payment, a loan or a debt forgiveness to which Division 7A applies). Additionally, entries representing loan repayments must be analysed to determine if they can be taken into account in working out the amount of a loan repaid or the minimum yearly repayment.

The balance of a shareholder's or beneficiary's loan account in the company or trustee accounts respectively may be in debit or credit at the end of the income year. Although a debit balance at the end of a year of income may indicate that there are loans that have not been repaid and a credit balance may indicate that no loans remain unpaid, neither result leads to the automatic conclusion that Division 7A does or does not apply.

If a private company has more than one shareholder's or beneficiary's loan account, the private company in calculating the Division 7A exposure cannot use a credit balance in one account to offset the debit balance in another account. Calculations of Division 7A loans are done in respect of transactions in the loan accounts of each individual shareholder.

 

Yes I did a loan agreement to someone once whose company was lending to a family member for something business related. We made the interest rate something like 7% but had a clause so it couldn't go below the Benchmark rate in case this increased to higher than 7%

 

I think this covers situations like Marge and Homer borrow from the company and Homer makes a repayment to the company - it has to come off his debt and no the debt of Marge.