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how does capitalised interest work?

Discussion in 'Finance & Banking' started by Triu, 6th Jun, 2007.

  1. Triu

    Triu Well-Known Member

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    Can someone explain in easy to understand language how capitalised interest works?

    I am paying my interest on my LOC against my IP and the cashflow is draining me. With capitalised interest do you not pay the interest at all and then pay at a later date?

    can someone help thanks.
     
  2. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Think of it like buckets of money.

    You have one bucket which is your cash (bucket gets replenished by your salary and other personal income)

    You have another bucket which is your LOC (bucket gets replenished by increases in equity that allow you to extend your LOC)

    Normally you take money out of the first bucket (your personal cash) to pay the interest charges on the LOC. If you capitalise interest, you instead take that money from the LOC bucket. This has the effect of increasing your loan balance. You still "pay" the interest, it's just that you use borrowed money to do so rather than cash.

    The trick is that as your loan increases, so do your interest payments. If your loan grows faster than you can add equity to the LOC (through revaluing your properties and extending the LOC), then you will eventually run out of money and be left with a huge debt and nothing to service it with. This is bad.

    It can work as a long term strategy, but only if the growth in your assets is always more than the interest rate you pay on your LOC. You are increasing your exposure when you capitalise interest - and because you are compounding the costs, (you have to pay interest on that capitalised interest), it can really eat into your equity and your safety buffers if your assets don't grow as fast.

    Alternatively, capitalising interest can work well as a cashflow management tool - this is how I use it ... I capitalise interest on my margin loan so that I can use my end of year distributions to pay for it, rather than needing the cashflow month-by-month.
     
  3. MattR

    MattR Well-Known Member

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  4. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    You need to get your own advice and be confident about the appropriateness of your structure and how you use it.

    Remember that Hart's case refers to a specific set of circumstances - and is not necessarily applicable to other situations.
     
  5. MattR

    MattR Well-Known Member

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    Each case on its merits, but this makes for interesting reading on the ATO site, particularly the last point under Common Mistakes.

    Rental property deductions for 2005-06

    Take care.
     
  6. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Again, this refers specifically to split loan arrangements. The whole point of the Hart case was that the investor entered into a "scheme" (involving a split loan arrangement) with the sole purpose of avoiding paying tax.

    If you don't have a split loan arrangement, then Hart's case isn't necessarily applicable (although may still be used as grounds for disallowing a claim, depending on circumstances).

    Like I said - get some good advice for your own circumstances.
     
  7. coopranos

    coopranos Well-Known Member

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    Like Sim said, my understanding of hart's case is that it is specifically related to split loans. I think this fact has even been pointed out in a case summary I read, although I cant find it now!
    The ATO did release an tax ruling suggesting that where a split loan was not involved it was possible for interest on interest to be deductible, however they subsequently withdrew that ruling for some reason.
    Anyway, my own opinion is that it should be fine as long as there isnt an argument that you are trying to avoid tax. If the expense is deductible I would think that normally the interest incurred on a loan to pay that expense should also be deductible.
    Of course at the end of the day if something doesnt sit right with you, chances are you shouldnt do it.
     
  8. willy1111

    willy1111 Well-Known Member

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    The thing I have been thinking about lately is that they were attacked for Part IVA, a scheme to avoid tax.

    Is it really avoiding tax - or is it arranging your affairs/finances in a way which will minimise your tax liability (and shouldn't everyone do that?(according to the late KP)
     
  9. MattR

    MattR Well-Known Member

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    Part IVA's purpose is to attack schemes whose sole or dominant purpose is to create a tax benefit - and the onus is on the taxpayer to prove otherwise!