Tax Tip 412: Strategy - Buy Main Residence using Substitution of Security and Getting Deductible Int

There may be a way for someone to sell an investment property, borrow to buy a new house, without qualifying for finance, and to be able to claim the interest even if the new house is the main residence.


Example

Homer is a young but retired investor and FIRE advocate. He has an investment property with a $400,000 loan secured by it. He has more than $400,000 in shares as well and has been living off the share income plus small amounts from his website. He wants to sell the shares, buy the main residence and then borrow to buy share shares.

He really wants to buy a main residence but cannot get finance. But he can potentially sell the IP and keep the loan open and substitute the security to the new main residence. Generally, to do this smoothly the settlement and purchase of the IP and Main residence would need to happen at the same time – not an easy task.

Another option is to sell the IP and keep the loan open with a term deposit as security.

This has been discussed here before, but it is difficult to do.


But Homer has another idea, pretty good one perhaps, and that involves selling $400,000 worth of shares paying cash for the main residence and then substitution of security for the loan to the new main residence soon after settlement. The IP will then be unencumbered.

The unencumbered IP can be sold without repaying the loan.

The money from the sale of the IP can then be used to buy the shares back.

But the problem with this is the interest on the loan would not be deductible because the loan that is now secured by the main residence was not used to buy the shares. It relates to the purchase of an asset which no longer exists so the interest on that loan cannot be deductible.


The solution?

Simple, before repurchasing the shares debt recycle, or loan recycle really. Take $400,000 from the sale and pay the loan down to $1 and redraw and buy the shares.

This way the interest on the loan will be deductible going forward if the shares are expected to pay dividends.


Homer may think that tax doesn’t matter because him and his spouse are only on $20,000 pa in income each so pay no tax anyway.

But he doesn’t realise that the interest on the loan can be claimed off the capital gains tax when the shares are sold – either by himself or the executor of his estate or the person that inherits the shares.

Make sure you get tax advice before trying this at home.

Based on:

How We're Buying A House During Early Retirement


See also

Loan Tip: What is Loan Recycling? Loan Tip: What is Loan Recycling?

Tax tip 342: Tax Issues with Loan Recycling Tax tip 342: Tax Issues with Loan Recycling

Loan Tip: Using a Term Deposit as Security for a Home Loan? Loan Tip: Using a Term Deposit as Security for a Home Loan?

 

I would want to see a binding ruling on the scheme element to the repurchase of securities and the application of Part IVA. Its akin to a wash sale intended to produce a tax benefit. I'm not sure the substitution of security argument works well as a defence since the scheme purpose appears intended to produce the deductibility. ATO may see a scheme when all elements are presented as described.

 

i didn't mean the same shares being purchased, but it could still be potentially viewed as a tax scheme.

 

Q @Paul@PAS @Terry_w

Loan 1 used to buy property A
Property A sold
Property B purchased
Same day settlement
Security Sub property A > Property B on Loan 1

Is Loan 1 debt now deductible on property B?

I have thoughts yes and no, as the property is sold cash from the sale used to buy next property.

 

No in my opinion but there would be an arguable case for it.

Ideally you would loan recycle by paying the loan down and instantly redrawing it

 

Yeah my thought is no - but could see potential for a private ruling.

Yes that would work, but can't see a bank repaying the loan, keeping it open, redrawing all for a same day settlement.

 

If it is a substitution of security type arrangement I wouldn't be posisble to do that. but If just a standard settlement it could be.

Either way I would just do it and the consider whether a private ruling should be applied for - might be better not to

 

No. The proceeds of the sale must discharge the old loan and then a new loan advanced to buy the new property. A clear path from that loan to pay for the new purchase must exist. If its the proceeds (equity) from the sale it fails. Without this there is no acquisition using borrowed funds. Changing security lacks any basis for changing deductibility. Its like borrowing from a bank and never using the borrowed funds to pay for a investment.

Had this occur for a client. They had a property they sold. The loan was fixed 1.99% rate. They could break the loan and discharge but considered it would be better to invest as a term deposit at 4%. They wanted to claim the deduction for interest. I said no interest is deductible. They invested cash proceeds (equity) from the sale not borrowed funds to start the deposit. If they had a redraw on the loan they could have refinanced but the rate would have been 4% ish. The old loan must be discharged. It stops being deductible when the property was sold. Not when its paid off.

 

Yeah that was my concern - loans not being repaid/redrawn.
Whilst loan sit there as investment, it's used to buy property A
Property A sold / cash used to buy Property B

 

They would be buying the new property with cash and proceeds from the sale basically.