Join Australia's most dynamic and respected property investment community

Tax Tip 46: Want to Pay IO on a PI loan?

Discussion in 'Accounting & Tax' started by Terry_w, 3rd Oct, 2015.

  1. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    How to Pay IO on a PI loan


    Recently the rules of the game have changed with many lenders increasing the interest rates on Interest Only (IO) loans. This makes it more attractive, in one sense, to take out Principal and Interest (PI) loans but the problem is that if you pay PI on an investment property you are diverting funds from paying down non deductible debt to paying down deductible debt. This means you will have less deductions which means you will pay more tax - over the years this would be considerable. Generally it may be better to cop a higher rate and go IO - at least until you would pay off all your non deductible debt.


    But there is a potential strategy to have your cake and eat it too.


    A person could borrow to pay the capital part of the PI repayment. Another IO loan could be set up separately to the main PI loan. This would probably have a higher interest rate - but if this is a LOC loan some lenders have lower rates for these compared with IO loans.


    Anyway, repayments for the main PI loan could be taken from this separate IO loan and then the borrower could pay the interest component of the main PI loan so that the IO loan is only increasing by the capital component and there will be no capitalising of interest.


    So far as I am aware no one has considered this before - I would patent it, but you cannot patent a strategy. Therefore there is no ATO guidance on how they would consider it. However under general tax law the interest would be deductible on both loans, with the only question being would the ATO see it as a scheme with a dominant purpose of increasing tax deductions.


    Anyone contemplating this should seek tax advice and consider a private binding ruling.
     
    chylld likes this.
  2. Peter_Tersteeg

    Peter_Tersteeg Finance broker and strategist Business Member

    Joined:
    18th Jun, 2015
    Posts:
    2,090
    Location:
    Melbourne, Nationwide
    An interesting idea, it does have two potential flaws:
    1. Borrower the extra equity to secure the additional loan.
    2. Borrower a surplus of serviceability to finance the additional loan.

    Unfortunately these are limited resources and this probably would cost an investor the acquisition of another IP or three. A more comprehensive cost/benefit analysis needs to be done.
     
  3. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    Pete - not flaws, but limitations.

    equity and serviceability would be needed for the extra LOC to pay the principal.
     
    Greyghost likes this.
  4. Greyghost

    Greyghost Well-Known Member

    Joined:
    23rd Jun, 2015
    Posts:
    1,259
    Location:
    Melbourne
    I agree.
    I guess the opportunity cost of employing this strategy will be weighed up against the principal amount over p&i of that loan and it's tax benefits.

    If it then fits within the requirements of that investors strategy then I like this concept..
     
  5. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    Spousal loans or other related party loans may be an option for those without equity or servicing. See my other tax tips and legal tips on these.
     
  6. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
  7. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    How to actually set up a PI loan to be IO.

    Steps:
    • Set up a separate LOC to that of the main PI loan.
    • Have the PI loan repayment drawn from the LOC
    • After the PI payment is taken from the LOC you can pay the interest component of the PI loan into the LOC
    • Let the LOC build up by the PI portion of the loan
    • Divert the extra cash you didn't use to pay down non-deductible debt.

    Example
    Jack has an investment property loan and a PPOR non-deductible loan. He naturally wants to avoid paying PI on his investment property so that he can divert funds to the PPOR. But his lender offers a 0.2% discount on PI loans for investment properties.

    Let's say the interest component on Jack's investment loan is $22,000 and the principal component is $8,000 = $30,000 per year in repayments.

    Jack could have the LOC pay $30,000 (yearly) into the investment loan and then Jack pay in $22,000 to the LOC. The LOC then has a $8,000 balance. That also means Jack has $8,000 extra cash in his pocket which he can use to pay down the PPOR loan. Jack continues to pay the interest on the LOC's $8,000 balance.

    Jack is not capitalising any interest. He is paying the interest in full. But he is also refinancing $8,000 of the loan each year by doing this.

    I don't believe there will be any tax issues with the above as there is no capitalising of interest. But seek your own tax advice before attempting this.
     
  8. Peter_Tersteeg

    Peter_Tersteeg Finance broker and strategist Business Member

    Joined:
    18th Jun, 2015
    Posts:
    2,090
    Location:
    Melbourne, Nationwide
    Is there a real life example specifying the lenders, amounts, rates, LVRs & products involved?

    I'm having trouble thinking of of a situation where this would actually be useful, given that:

    1. I can only immediately think of mainstream two lenders that differentiate on pricing between IO and P&I investment loans (NAB & Macquarie and both will negotiate this difference and more away).
    2. LOC products uniformly cost more than IO investment loans even when secured against a PPOR.
    3. Introduces more risks such as:
    * poor management could lead to contaminaition of deductibility.
    * increased chance of an ATO audit (even if compliant an audit is unplesant and costly).
    * lender can call a LOC balance at will and leave you with an undesireable P&I loan.

    The only real benefit I could see in all this is it allows a loan to be IO for up to 30 years without having to refinance. If you've got the surplus equity and serviceability to implement this scheme, then a limited IO period is easily handled.
     
  9. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    No specific example, but i was thinking about a client with NAB loans. We just managed to extend the IO period another 5 years but it comes at a cost.

    LOC products do have higher rates, but this would only be a small cost for the benefit of paying an extra $8000 off the main residence per year for example. The LOC interest would be deductible too which reduces its impact.

    Once the LOC limit has been used the LOC could be converted to a term loan too.
     
  10. Peter_Tersteeg

    Peter_Tersteeg Finance broker and strategist Business Member

    Joined:
    18th Jun, 2015
    Posts:
    2,090
    Location:
    Melbourne, Nationwide
    NAB was my immediate thought as well, but we're getting the same pricing for IO and P&I investment rates with them at the moment for anything 80% or lower. They were certainly out of market for about 6 months, but they're on their way back and they're accomidating for repricing older loans on a level playing field with new money.

    If the borrower has the servicing capacity to qualify for a term loan as well as the acompanying LOC, surely they'd be able to qualify to extend the IO period or refinance elsewhere? The fees in maintaining a separate LOC over 5 years with the NAB are likely to be greater than the cost of refinancing.

    What's being proposed isn't recycling non-deductible to deductible debt, it's transfering a deductible P&I loan to a (more expensive) deductible evergreen IO loan. It's not paying off a non deductible loan against a main residence unless you do decide to throw in some interest capitalisation.

    If you're simply going to convert the LOC to a term loan, you might as well have gone with the IO term loan in the first place. The NAB would want the term loan to be P&I at this point as well.

    I'm the first to acknowledge the frustration in extending an IO period these days, but in practice this solution is more likely to be unnecessary and costly, or it can't be implemented in the first place.

    The best solution (that I can think of so far) for extending IO periods is to do some decent forward planning and have a strategy to extend right from the time original loan is set up. Admittedly it's inherantly difficult to do this given how much everything changes over a 5 year period.
     
  11. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    I am also thinking of planning ahead if serviceability tightens up further. I might write another post about this and a possible solution.

    Another reason to get PI is serviceability.
     
  12. Rob G

    Rob G Well-Known Member

    Joined:
    16th Oct, 2015
    Posts:
    167
    Location:
    Melbourne
    A few issues to consider Terry.

    Refinancing a presently existing liability is a valid strategy, however:

    1. The specific purpose of the overall scheme is to borrow/refinance only the capital repayment component which would not have otherwise been deductible if paid directly.

    2. A debtor cannot by default specify if the partial repayment of the LOC is to come off the principal or interest component, in fact the LOC is merely an intermediate global loan on the IP and interest will capitalise.

    3. Does this amount to the 'refinancing principle' ? The new borrowing is swapping debt for what would otherwise have been equity. The Commissioner does not accept that this is possible for sole traders or mere passive asset owners, TR 95/25.

    4. The scheme bears more than a superficial similarity to TD2012/1.

    5. Disregarding the tax effects, the most reasonable commercial alternative having regard to interest costs in your facts is that the taxpayer would have chosen a straighforward PI, s.177CB ITAA36. There is a tax benefit. It is now down to dominant purpose of any person, having regard to form and substance, etc. (refer to point 1).
     
    Terry_w likes this.
  13. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,942
    Location:
    Sydney
    Thanks for your comments Rob. All valid points but I don't think there is a similarity to TD2012/1 because you are not capitalising interest.

    here is an example

    PI loan results in a repayment of $1200 being $200 principal and $1000 interest.
    On July 1 the payment is debited from the LOC which has a balance of $0.
    The balance now is -$1200
    Part of the borrowing was used to pay interest and part principal
    This involves capitalising interest so far
    But on 01 you make a deposit into the LOC of $1000
    You have paid the principal component (technically the loan is mixed though)

    The balance of the LOC is then -$200

    Yes you would be swapping equity for debt. But this should amount to the refinancing principle because you are not really borrowing capital.

    Maybe the steps could be changed around so your payment is made into the LOC before the debit for the repayment on the main loan is made. But there is mixing issues.

    The alternative postulate is to get an IO loan - which may not be possible without changing lenders which you may not want to do...