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

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.

 

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.

 

Pete - not flaws, but limitations.

equity and serviceability would be needed for the extra LOC to pay the principal.

 

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..

 

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.

 

Legal Tip 38 Spousal and Related Party Loans https://propertychat.com.au/community/threads/legal-tip-38-spousal-and-related-party-loans.1872/

Tax Tip 47: Spousal Loans as a Tax Strategy https://propertychat.com.au/community/threads/tax-tip-47-spousal-loans-as-a-tax-strategy.4452/

 

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.

 

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.

 

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.

 

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.

 

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.

 

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).

 

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...

 

@Terry_w, I know someone who did this. However the way he did this using multiple lender

PPOR
PI with Lender A

Investment Property 1
I/O with Lender B
LOC with Lender B

PI direct debit to LOC, and LOC interest paid full.

I remember he mentioned its tricky with the same lender, so he setup that practice. But principally, is exactly same with your explanation.

Its doable, but not common and not tax deductible. I believe his accountant mention this is not capitalizing interest. The only reason I don't like this idea as I will pay more (LOC rates usually higher than PI)

But I'm not an accountant, so..

 

I can't think of a reason why Part IVA would NOT apply to a scheme to capitalise interest through borrowing to pay part of the loan repayment on a ongoing basis. I agree to all the points raised by Rob and do think there is a tax benefit and a dominant purpose. I'm not convinced the ATO would issue a private ruling that isnt conditional to Part IVA. Or just refuse to issue a ruling.

I'm struggling to find valid reasons why a taxpayers dominant purpose would not arouse a Part IVA concern. It seems like a scheme and capitalises interest with no substence beyond a tax benefit. Throw a non-deductible loan into the mix (which the ATO would explore) and use the cashflow savings from the IO to favour the PPOR loan its fatal as a undisclosed element to the proposed scheme. Its what the lenders did with split loan facilities without mention of the non-deductible.

It may also act as a massive red flag to any lender if the borrower cannot service a loan other than by using an unreported loan facility to make the capital payments. I would seriously doubt any lender would allow a reported facility of this kind to a new loan.

Terry - Div 290 TAA 53

 

I wonder if this would apply to me.
Although different to the purpose given.

As a non-resident I can not get IO (at all)
I have 2 properties (both on P&I).
I am also on 65% LVR so I have a lot of equity.

My offset means I am paying down more principle than the loan calculates me to require paying down (since less of the repayments are interest than they calculate it to be for that repayment amount). This means I also have less cash flow than what should be needed to pay the loans off in 30 years.

I would like to get a third property on IO so that the 3 properties would still overall be paying themselves off and the 'extra' that is paid off by P from P&I due to the offset would be offset by IO on the third loan.

If I get a third property on P&I and get a LOC to pay the P, this would be worthwhile for me (even at the higher rates) as it would balance out the total repayments to be closer to the real amount needed to pay them off on P&I had I sunk all of my offset into the loan.
Not sure if I can get a LOC though if I am unable to get IO. Have not looked into this.

 

This is what this thread is about. You should get some tax advice and consider applying for a PBR. But better to make sure you ca qualify for a LOC first.

 

What is a PBR?

 

This isn't a scheme to capitalise interest. It is a scheme to borrow principal and pay the interest.

And it is not a scheme that I am promoting or have even implemented, but an idea that may or may not have legs.

 

Pretty Bloody Ridiculous or a Private Binding Ruling.