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Tax Tip 63: Don’t cause borrowed funds to take a detour

Discussion in 'Accounting & Tax' started by Terry_w, 21st Oct, 2015.

  1. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Where borrowed funds are taken from a loan and put into another account, such as a cheque account, with other funds, and then used the interest on those borrowed funds will either not be deductible or at best only deductible in part.

    Once the borrowed funds are in a savings or cheque account they are no longer borrowed funds. And then once borrowed funds are mixed with other cash then it is impossible to separate the borrowed funds - (like mixing milk and orange juice and trying to take out the milk).

    It doesn’t matter if the funds are in the account for just 1 or or 1 hour it will be impossible to rectify the situation. It may be possible to repay the money into the loan and to reborrow, but this will only fix the tax problem if the loan is not mixed. If the loan is mixed (money used for 2 or more purposes) then paying back into the loan will further mix it and create a better mess.

    For a AAT case concerning this matter see

    Domjan and Commissioner of Taxation) [2004] AATA 815 http://www.austlii.edu.au/au/cases/cth/AATA/2004/815.html

    Summary: Best to avoid taking your borrowed funds on a detour and pay directly from the loan account.
     
  2. chylld

    chylld Well-Known Member

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    This is such an easy trap to fall into.... when I was at the bank asking for a chequebook for my LOC (to buy some investments) they said "you can't get a chequebook for that account, but you can for your savings account, here let me transfer it there for you first" *click click click* "WAIT STAHP"
     
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  3. Propagate

    Propagate Well-Known Member

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    What if there's no other option, like when the loan is a basic no-frills affair and the only way to access additional funds from it is for the bank to transfer it from the loan into a chq account with the same bank first, then you access it from the chq account? I realize if the chq account was already running and had personal money flowing in & out it would be a disaster, but if the chq account was a brand new account, solely for the purpose of a gateway for the loan funds to be actually made available on-payment for investment purposes, would this be acceptable as long as the chq account never saw a cent of anything other than that particular loan and was fully traceable to the original loan? Cheers.
     
  4. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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  5. chylld

    chylld Well-Known Member

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    This worries me a bit... some of my friends are with NAB and their broker wouldn't give them a proper LOC for their equity release; they got a new SVR + offset instead. Does NAB not have a LOC product?
     
  6. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Yes it does. But the rate is much higher than the normal loans. I got a client of mine a LOC with them about a month ago. The intention is once they use it we will then change it to a term loan.
     
  7. chylld

    chylld Well-Known Member

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    Will the account number (and thus transaction history) stay the same? Allowing the ATO to look up the investment transaction in the LOC/loan's history?

    Or is it a new account and not matter anyway since the new SVR subsumes all of the LOC's debt and the purpose is carried over?
     
  8. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    It won't be the same number, but that doesn't change anything with deductibility.
     
  9. Propagate

    Propagate Well-Known Member

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    Interesting thread that you linked me to, thanks Terry. Seems it's not uncommon. I've only done 2 refi's before, and both times surplus funds were kept in their own new loan split to be drawn whenever needed, nice and easy and I assumed that's how all banks worked.

    Man, it's so annoying. All the bank has to do is NOT pay out the surplus to me, then all would be well in the world again and not have to worry about "maybe's".

    I don't have a lot of choice at the moment, I spoke to the bank earlier, I may be able to add a redraw option to the loan account but it can only be done after it has settled, then that can take 5 days, then pay the surplus back to the loan, then re-draw it to where it needs to go (assuming they can do that direct from the basic loan and not have to go back into the bank account first anyway!! - back to square one then)

    I think I'll just have to run with the "maybe". It's a brand new bank account which will activate at settlement, surplus won't be in it long enough to gain any interest to contaminate it that way and I certainly wont be putting any other funds in. It'll get the surplus funds in and they'll be pulled straight back out directly to pay off another loan split, and the transaction account will be closed. No chance of it mixing with none-investment related monies and all traceable. I'll just have to hope that's good enough for the ATO should I ever get hauled in.

    Can't see another way around it.
     
  10. Propagate

    Propagate Well-Known Member

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    Thinking about it, doesn't paying back to redraw then pulling out again break one of the other rules though? The one where once you pay down dome of the loan you can't claim deductions on a subsequent increase?

    e.g.

    IP Purchased for $500k
    Bank 1 loan - $450k - Security is the IP
    Bank 2 loan - $50k deposit & costs - Security is PPOR
    TOTAL Borrowings for IP = $500k 100% deductible

    Down the track there's enough equity to make IP "stand alone" and pay out the $50k PPOR split, but a refi will disburse all funds at once from the new bank. So, say you had a good run and there's heaps of equity, new bank gives you a brand new loan of say $600k. You ask for two splits, one for $500 to pay out the original loan plus the deposit loan, and the balance in it's own split for future use on another deposit say.

    Now, bank says "hold on" they disburse $450k direct to the original bank to pay the loan out but the $50k for the deposit split has to go into one of their checking accounts first, as there is the $50k loan is not secured against the IP and they won't disburse the "surplus" $50k to an account outside of their bank, (i.e. to the PPOR split loan). So, you have the situation I mentioned earlier, taking that $50k and paying out the original split but it has taken a detour into a clean checking account first.

    The re-draw alternative scenario looks like this, pay the $50k surplus straight back into the loan account first then redraw it straight to bank 2 loan - great, no detour...

    BUT - by paying the $50k back into the loan, you have reduced that loan from $500k to $450k, then drawn it back out to $500k, my understanding is that because the total loan balance for that property was essentially paid down by $50k then you could only ever subsequently claim deductions up to $450k from thereon? Making it a pointless exercise paying it back to redraw, may as well pay it from the checking account and just not claim deductions on it?

    Am I missing something, or in the above case would it it better to run with the "maybe" situation of the short, traceable detour?

    Cheers.
     
  11. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    The bank will disburse funds as instructed. If they pay $50k into the loan account at the other bank relating to the $50k borrowed for the IP then this is just a straight refinancing of that loan.

    If they pay $150,000 into a savings account first then the funds will not be associated with an investment. i.e. you are not borrowing to invest. If the savings account is clean with nothing in it, then you can argue the tracing of the funds and that it is no contaminated. You can then use $50k to refinance the $50k loan.

    but I see what you are getting at as the $150k will be a mixed loan. You are diverting part of it to pay off another loan.

    Paying into a mixed loan will dilute all parts of the loan.

    Best to split all loans before paying off first.
     
  12. Propagate

    Propagate Well-Known Member

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    HI Terry, sorry, maybe I wasn't too clear in my post. The problem is, the new bank won't disburse to the $50k split secured on the PPOR, they will only disburse to the original IP loan, with any surplus having to go into an account with the new bank. They wont leave it un-drawn either, or allow you to pay out anything other than into one of their own accounts.

    So, if the $50k "surplus" is automatically paid into the new checking account first, then paid back onto the loan to be re-drawn across to the pay out the $50k PPOR split, when it goes back into the loan prior to redraw then technically that's the principle amount reduced by $50k for a period? Does that mean when re-drawn to pay off the $50k split it can't actually be claimed as deductible any more as, for a short period, the maximum loan for the IP was reduced from $500k to $450k and you can't subsequently increase the borrowings for the same investment?

    Hope that makes sense....?
     
  13. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Hi Propagate. Sorry I don't think I follow. Can you do an example with numbers - current and future situation.
     
  14. Propagate

    Propagate Well-Known Member

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    I'll try..

    See if this makes sense.

    Loan 1 (Bank A) = $400k - Security on IP1 purpose for IP1
    Loan 2 (Bank B) = $50k - Security on PPOR purpose for IP1

    Total Borrowed = $450k = of which interest the whole $450k is claimable

    House value has increased enough to refinance all $450k with Bank C, but Bank C will only pay $400k direct to the bank that it is discharging, with the surplus balance only able to be paid into a new checking account with Bank C. They won't pay a portion of the new loan direct to Bank B on disbursement.

    So,

    Loan 3 - Bank C pays $400k direct to Bank A and takes over security of IP, Bank A is now out of the picture.
    Bank C pays the $50k surplus into a new Bank C checking account, as it won't pay it straight to to Bank B on disbursement and won't leave the surplus undrawn
    Bank C is now fully drawn at $450k ($400k for IP1 $50k in new cash account) but Bank B still has a $50k loan secured against the PPOR

    So, if we can't use the "cash" surplus from the new Bank C checking account to pay out the Bank B $50k, then the $50k from the checking account gets paid back into Loan 3, reducing the loan amount to $400k but now has a redraw available of $50k.

    The redraw is then taken out to pay out the Bank B $50k loan.

    That result now is that new Loan 3 with Bank C is fully drawn at $450k and Loans 1 & 2 with Banks A & Bank B are out of the picture.

    Total Borrowed = $450k - all secured against IP1 and purpose for IP1....

    ....BUT, this is the bit that's confusing me. In order to be able the redraw the $50k from Loan 3 it was first paid back into the loan, thereby reducing the loan amount from $450k to $400. It's then re-drawn to pay out Bank B $50k so increases back to $450k.

    Does that mean that, as the new loan was effectively paid down to $400k for a time, then only a maximum of $400k would then be deductible going forward?


    Here's another one then, if paying the detoured cash back into the new loan and redrawing it direct to the old loan is OK, how is that fundamentally different from paying the detoured cash direct to the old loan? It's the same cash and ends up in the same loan either way, only with one less step. Ah, got it. it's not technically borrowed money if it's not coming directly out of the loan account. But! that then gets us back to the above, you've effectively paid the cash off the loan then redrawn it again, doesn't that mean you've reduced the principle so whatever you re-draw back out, if it's for the same IP, can't be claimed anyway?
     
  15. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Ok I see.

    but there is a simple solution. Have the $50k paid into a clean bank account and then from their use it to pay off the $50k loan. Putting it back into the original loan will be paying off debt and you will lose deductions on $50k.

    using a clean bank account is not ideal - see tax tip 1 - but the only other solution is to increase the loan with bank A, pay off the $50k loan and then refinance.
     
  16. Propagate

    Propagate Well-Known Member

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    Thanks Terry. Loan increase with Bank A was not possible in this situation. At least the new Bank C sets up a spanking new clean checking account, and the surplus will be moved out to Bank B literally the day it hits the clean account, so no chance of it getting mingled with any other type of cash.

    Would be a whole lot easier if they would simply let you nominate where you wanted surplus funds to go, or simply not automatically fully draw them rather than forcing you to open up a checking account with them for the sole purpose of them forcing you to draw down the whole loan. The cynic in me thinks it's all a ploy to force you to open an account with them.

    Cheers.
     
  17. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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  18. Propagate

    Propagate Well-Known Member

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    Thanks Terry. Glad you were able to decipher my ramblings. Cheers.