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Capitalising Interest Loan?

Discussion in 'Real Estate' started by AussiePaula68, 18th Jul, 2009.

  1. AussiePaula68

    AussiePaula68 New Member

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    Does anyone have any thoughts on if its a good idea. We've been advised to purchase our first investment property and set up the loan so that all the rental income goes directly towards our own mortgage (thus paying it off quicker) while the ip loan has no payments made against it so the loan keeps getting bigger. It makes sense with all the tax benefits but it sounds risky. I've yet to find any positive opinions online about this kind of setup:(
     
  2. Billv

    Billv Getting there

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    Not a good idea IMO,
    Who's your adviser? :eek:
    give him the boot asap

    From what I understand the current ATO position is this.
    If you capitalise interest in order to do "something else" with the money then the purpose of the capitalised interest is considered to be related to that "something else". So if you are capitalising interest on your IP loan so you could pay off your PPOR then you contaminate your IP loan and that part of the loan is no longer tax deductible.


    Read about TD 2008/27EC and if you still want to go ahead with it ask the ATO for a private rulling telling them that you can't afford to hold the IP if you don't capitalise etc etc
    and see if it passes.

    TD 2008/D12 (Finalised) - Income tax: is the deductibility of compound interest determined according to the same principles as the deductibility of other interest? (As at 3 September 2008)
     
    Last edited by a moderator: 19th Jul, 2009
  3. AussiePaula68

    AussiePaula68 New Member

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    Thanks for that. :)
     
  4. GregR

    GregR Reid Consultants

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    AussiePaula68,
    It is a relatively common strategy to use rental income to pay down your personal debt. There is no requirement that any particular income needs to be matched against a particular loan vehicle. You need to set up your loan structures correctly in the first place so not to 'confuse' the personal from the investment. The ability to direct rental income (or dividend) and tax benefits (income tax variations or returns) to pay down non deductible debt first is very effective in reducing that type of debt.

    As a result, you could service the investment loan using further debt which in turn the interest component can be claimed as deductible. I would set it up that the IP loan is not directly compounding and is an interest only loan so it does not increase (although a LOC that services that IP loan will). I agree with Bill, get some independent tax advice from someone who understands and works in the property investment area.

    Another piece of ATO ruling that you may like to read is: ATO ID 2006/298
    Income Tax Deductibility of compound interest on a line of credit facility

    We need to use strategies better to increase our wealth, not fraudulently or illegally but smarter.
     
  5. ashwright

    ashwright Well-Known Member

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  6. shasta

    shasta Member

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    Jeez, be careful. Again, i'm no expert, but here's my take.

    There are two issues, i think.

    1. The tax deductibility of what you're doing. Depending on how you structure it, you might not be able to tax deduct the accruing interest if the ATO thinks that you've 'contaminated/mixed' personal and investment loans.

    2. Potentially the more important issue is the intent of the whole set-up. If the major benefit is that you accrue more and more interest costs that are tax deductible then the ATO may deem that the primary purpose is to reduce tax and that the commercial purpose of paying off load faster is a secondary issue. In this case, the ATO will classify what you're doing as a scheme and that is illegal. Its illegal to set-up a scheme with the primary purpose of avoiding tax.

    Read following from ATO website:

    WHAT ARE TAX MINIMISATION AND
    TAX AVOIDANCE?
    Tax minimisation is when taxpayers legitimately arrange their
    affairs to reduce the amount of tax they pay. It complies with
    both the letter and spirit of the law.
    Tax avoidance is when taxpayers try to improve their financial
    position through arrangements that may:
    ■ comply literally with parts of the law but not with the intention
    ■ be defeated by anti-avoidance laws.
    HOW DO YOU RECOGNISE A TAX
    AVOIDANCE SCHEME?
    The following characteristics, alone or together, are signs of
    tax avoidance schemes.
    The scheme:
    ■ is contrived or artificial in the way it is carried out
    ■ uses complex structures or intra-group transactions to create
    tax benefits which are not related to the commercial activity
    ■ involves a low level of financial risk and a large tax benefit
    that you would not expect in a commercially driven
    transaction
    ■ is aimed at duplicating the tax benefits of a single investment
    or activity, whether within Australia or between Australia and
    another jurisdiction
    ■ is based on assumptions, including ‘blue sky’ projections,
    which can lead to
    – asset valuations that seem excessive
    – inflated deduction claims
    ■ includes any of the following
    – round robin finance
    circular funds movement– non recourse or limited recourse loans to be paid off by
    future earnings
    ■ contains mechanisms for winding up or exiting an
    arrangement before net income is generated for investors
    or to avoid collection processes
    ■ is not carried out according to contracts or other legal
    documents
    ■ abuses concessions within the tax laws or seems to go
    against the policy behind those concessions (eg research
    and development or primary production concessions)
    ■ uses tax exempt entities (eg charities), or entities with
    accumulated tax losses, to wash income
    ■ defers income or accelerates deductions to defer or avoid
    paying tax altogether
    ■ involves a tax haven or bank secrecy country without any
    sound economic reason
    ■ may include
    – large up front deductions
    – inflated fee prepayment
    – guaranteed returns
    – little direct involvement by investors.

    You might also want to look up the Hart's case. Hart v's ATO related to this issue, and i think that Hart lost?
     
  7. Redman

    Redman Member

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    Location:
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    Hi all,

    A related question that may help AussiePaul68 also,

    What if you had an IP, IO loan, and deposit all the rental income into your PPOR offset account (save on non-deductible interest). You pay for the interest on the IP loan from a LOC (secured by the PPOR), BUT you pay the interest on the LOC from the PPOR offset, ie do NOT let the LOC capitalise. Therefore, the IP loan will not grow or shrink, and the LOC will grow, but not because of capitalising the interest.

    Am I correct in saying if you do this, the interest on both the IP loan and LOC (also used for buying costs, deposit, and maintenance, etc.) would be safely deductible?

    Cheers,
    Red.
     
  8. Billv

    Billv Getting there

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    This is similar to what GregR was referring to.
    Safely deductible? I don't know about that...
    deductible? maybe of you can justify your reasoning for doing so to the ATO (at audit time)