Tax Tip 53: Paid Deposit with cash - how to fix big mistake before settlement

Hi terry

Yes this one makes more sense, I have no issues getting the principle of this because there is a home loan so tax deductions will be applicable . But it's tax tip 53 example I still fail to get. Is the context the same as tip 60, where you have a second loan on the side that's already accrueing interest?

 

This tip - 53 - is above fixing a mistake. Having use cash and replacing it with borrowed money.

 

This all makes sense. You should never pay a deposit for an IP with cash if you can avoid it. Rule applies to stamp duty and other costs as well. Always maximise deductible debt.

But I am wondering whether you can avoid this in all cases. Take this example. Assume you have no PPOR debt, but significant IP debt (all deductible). You then get cash windfall (eg estate settles) of $200k in cash. You intend to buy another IP using the $200k cash as IP deposit, and borrow ~$600/700k.

How do you borrow 100% in that case? Assume you do not have enough redraw to borrow $200k against existing IPs.

The example above is not all that different to first home buyer. Wants to buy first IP and has $200k deposit, all saved in cash. Will borrow $600k to buy IP (assume $750k purchase + $50k in costs).

How can you structure this to end up with $800k in deductible debt, and not $600k in deductible debt?

 

2 ways
a) related party loans.
e.g. husband inherts, wife buys a property with a loan from the husband. or a related company or trust buys.
careful legal planning needed

b) cash as a term deposit.
Prob not practical unless the property will quickly grow in value.

 

Thanks Terry. Useful as always. Re B), I am not familiar with the concept of cash as a term deposit. Let’s say husband inherits $200k, gifts or loans the $200k to wife for asset protection, but as she also happens to be on much lower MTR, this has preferable benefit of lowering ‘household’ tax. Wife puts $200k in term deposit in her name.
Husband buys $750k property in his own name with full $800k borrowed ($50k for costs) in own name. Security is property and $200k term deposit in wife’s name. Husband and wife could both be on loan contract, but property is negatively geared in husband’s name only.

 

Yes could be possible like that but probably not recommended.

Gift to a discretionary trust might be cheaper and easier. Trustee loans it back and buy in personal name

 

Instead of the trust buying the property, couldn't you gift the 200k to the trust, then have the trust loan it back to you?

 

Yes, that works. Retains discretion over distribution of income on the $200k held by trustee, while full $800k is deductible ($600k from Bank, $200k from Trust) in husband’s high MTR. Nice.

 

Yes, if I understand Terry correctly, idea is to gift deposit to trust, and trust lends to person on high MTR. Person on high MTR owns property in own name, with full deposit + bank loan tax deductible.

 

Yes that's what I mentioned above in reply to harry

 

Some other considerations come to mind with this approach of never using cash as a deposit:

1) The loan from the trustee is presumably unsecured or would have a second mortgage as the main loan from bank would take first mortgage. Don’t hear much about 2nd mortgages any more, do they still exist? If unsecured, would suggest higher interest rate should be charged by trustee.

2) In tighter lending market, one of course would need to consider any negative impact on servicability of the loan (for the deposit) from the trustee. In my example, if you are approved by bank for $600k, you may not be approved for $600k + $250k (for deposit + costs) = $850k). Or if you are trustee, would bank treat loan from trust differently to normal bank loan re servicability?

Terry, great thread, terrific structuring tips.

 

Second mortgages still are common and could be legal or equitable mortgages. Interest rate could be nil or market rates or somewhere in between.

banks will generally consider borrowings from a related entity as debt for serviceability purposes. But, some will disregard it in some circumstances.

 

Updated version of the original post.

Never pay for a deposit on an investment property with cash if you can avoid it, and you can avoid it in most cases. But what happens in you have a momentary lapse of common sense and do pay the 10% deposit with cash only to realise a few days later it was a mistake


A few possible options

1. Cancel the cheque - if you are quick enough. And then use the borrowed money, even from redraw if need be (not ideal but this can be fixed up later);
   
   
2. Ask the agent to refund your deposit and then repay using borrowed money. The agent will be holding your deposit on trust until settlement so it hasn’t been paid to the vendor yet. But they are obliged not to release it until the Vendor directs.
   
   
3. Draw a bank cheque for the deposit amount and hand this to the agent on the condition they release the deposit back to you.
   
   
4. Pay the deposit twice. The second time with borrowed money. Upon settlement any excess should be released back to you - make sure it doesn’t get used at settlement. This is not ideal however as the borrowed money will be mixed with cash while it is with the agent and upon return you cannot really say that you got back the non borrowed money.
5. Don't use the deposit money in the trust account. At settlement use borrowed money from elsewhere to pay the vendor, not touching the deposit already paid. As this money is being held in trust it can returned to the purchaser after settlement.

I think number 5 is the safest option.

Before doing any of these seek legal advice as there are many legal complications.

Also seek tax advice, including general advice on the deductibility of interest and advice on whether the ATO could deny the deduction under Part IVA.


ps - why is it such an issue? On a $1mil property 10% = $100,000. If you paid this with cash that is approx $5,000 (at 5% interest rate) per year less in tax deductions for the period you hold the property. A lot of money.

Key words: Deductibility of interest; loan structuring

 

Great post by Terry, which may help my situation. We recently purchased an IP, paid 10% deposit using what I thought was "borrowed" money. After reading other tips posted by Terry, I now started to doubt whether I have done the right thing. The purchase has not been settled yet hence I present the case here to seek opinions from professionals.

Long story short, a few years ago I set up a separate loan for envisaged IP purchase. When it was set up, it has 270k fully drawn loan (interest only) with an offset account parked with 270k cash.

A few years on, no IP was found and no interest or principal was paid. Early 2019, I used the cash in the offset account to purchase some shares hence incurred interest on the loan, which was paid automatically from the linked offset account.

Later 2019, an IP was eventually purchased, and 10% deposit was paid using a cheque linked to the offset account. After the cheque was handed over and before it was presented to my bank, I transferred 40k into the offset account, to fully fill the gap caused by share purchase and associated interest deduction. Now balance in the offset recovered to 270k, fully offset the 270k loan.

A few days later, the 10% cheque (say 90k) was presented to my bank, so the balance of the offset account became 180k. Another few days later, bank called me to transfer 180k from offset into the loan, for the sake of starting a separate IP loan upon settlement. I did that as requested, so it led to a 90k loan balance with $0 in offset.

The separate loan I mentioned is a 105% LVR interest only loan. At the settlement, the 90k loan will be closed and I will have only one loan (105% LVR) for the IP. If I do nothing before the settlement, the new loan will likely to be seen as having a 90k component refinanced from the previous loan, which I am now uncertain if it can be labeled as 100% borrowed money for the IP purpose.

Any comments and suggestions are really appreciated.

 

See my tax tip 1 and seek tax advice

 

Hi Terry,

Thanks a lot for your advice. I understand that it was really a mistake to pay the deposit from the offset account. In my case, to the worst $40k out of the $90k deposit can be reckoned as not from borrowed fund.

Since there are still a few weeks before settlement, I may fix it following the 5th (safest) option in your previous post. This however requires me to either pay down the $90k loan to zero or $1, and then direct all new borrowing (105%LVR, in a separate loan already setup) to pay vendor and stamp duty directly. Then, refund the deposit back to me into my saving account after the settlement has been completed.

I need to check with my solicitor and bank to see if this is possible. Actually, the letter from bank to solicitor says the fund available for settlement is 105% of purchase price minus $1 less fees and charges. I now recall bank told me that the $1 is the amount refinanced from the $90k loan.

 

Thought of asking a question which may already be answered elsewhere: if deposit is not touched at settlement ( as new loan from bank is sufficient to cover the full purchase price plus stamp duty), what arrangement would be needed to assure vendors' sale agent to receive their fees? I thought part of the loan can be withhold at solicitors' account and be released to the agent at or after the settlement. But I do not know whether I am right.

 

If you are the purchaser it doesn't matter as you are not paying the agent. But you could direct that at settlement that part of the money goes to the vendor and part to the agent.

 

Hi Terry, thanks a lot for your prompt reply and advice.

 

Timing varies with property equity and proceeds availability etc. If its not requested (by the vendor to the buyer eg to pay a deposit on a new purchase one loan payout & equity are confirmed) prior to settlement it is vendor property at settlement and the agent fee will be settled then too. ie the vendor would receive the deposit minus the agent charges. Dont worry the agents will make sure they get their $$$