Interest Deductibility - Equity in Investment Property

I have a situation whereby I have the following scenario:

1. Value of Investment Property: $500K
2. Interest Only Loan on Investment Property: $300K
3. Equity in Investment property: $200K
4. I would like to refinance the IP loan and increase it to $400K, giving me $100K in funds to play with ....
5. I would like for all the interest payable on the IP Loan to be deductible
6. I would like to reduce my home loan

Is there any way I can use the funds from the equity in my investment property ($100K) to pay-off my home loan so that I can still get a full deduction on the entire investment property loan?

I'm proposing the following:

1. Refinance the IP Loan to $400K interest only
2. Setup a Mortgage Offset account for the IP Loan and have the $100K in credit sitting there
3. Start Date would have $400K Loan LESS $100K - i.e. interest will only be payable on Net IP Loan of $300K (at the beginning of the loan period)
4. Each month, the interest repayments will be taken from the Mortgage Offset Account eg If Interest for Month 1 was $2K, this would be taken from the $100K of available funds in the Mortgage Offset account, reducing the balance to $98K and increasing the total Net IP Loan Balance to $302K.
5. For Month 2, the interest repayment will increase given the Net IP loan has increased to $302K. Say if interest is $2.1K for the month, this would be taken from the mortgage offset account of $98K leaving a balance of $95.9K and increasing the net IP Loan to $304.1K ............ etc etc for years 3, 4, 5 etc
6. Eventually, over a period of time, say 4 years, the IP Loan balance will reach $400K and the mortgage offset account will be zero
7. I would have increased savings over the 4 year period (increased savings due to non-requirement to make personal contributions to IP Loan)
8. On a regular basis, I would contribute amounts to my home loan
9. After 4 years, I would have reduced my home loan by $100K but increased my investment property loan by $100K
10. Rental Income derived from the property is used to pay off my home loan

Will the above scenario allow me to claim 100% of the interest deduction on the IP Loan? If not, are you aware of any other strategies that will allow me to use the equity in my IP to pay off my home loan?

 

Effectively all you are saying is you will be capitalising your interest on your IP, and shooting all rental income into non-deductible debt.
I am not aware of any cases where this has been tested, but my own personal opinion is that the ATO cant really tell you where to put your business income so they shouldnt be able to tell you what to do with your rental income.
It has however been tested with a split loan facility which has been knocked back by the courts. It seems that the way you structure it is very important.
Possibly the simplest way to do it is get all your rental income put into your every day transaction account, and set up a line of credit against your rental property. All interest repayments from the rental property come from the LOC. You then make whatever payments you decide to make against your PPOR from your transaction account.
There was a great thread on the topic over at somersoft, and someone did a really good graphical flowchart showing a good way to set it up, but i dont have the link. possibly do a search over there on "interest on interest" or similar

 

I will say that it could work but the ATO could test your reasoning in doing this.

It's a fine line between tax minimisation and tax avoidance.

For example, the ATO inspector could say that you arranged this structure to avoid paying your fair share of tax.
What is your reasoning behind such a structure?

Have you got cash flow issues perhaps?
Some people would have no hope in paying a PPOR loan as well as an IP loan so they have no choice than to borrow in order to pay the interest on their IP's.

Then why don't they sell?
Because the property market is moving upwards and their net worth is improving, or the market is not going up but the investors hope that sooner or later it will recover and turn around.

As long as you have a valid reason for doing what you have to do
then IMHO there should be no problem with the ATO.

Cheers

 

There are safer ways that are promoted so I guess they are based on legal advice.

Search "debt recycling" on this site to get a wider range.

The only concern I have with your method is that there is no other purpose on the extra drawing except to gain a private advantage.

If you (1) took cashflow from your IP and paid down your PPOR debt and (2) immediately redraw from investment loan to (3) buy more securities/investments then you could argue that the purpose of the extra borrowing is to derive your assessable income.

When you capitalise interest, it invites scrutiny as to what you otherwise are doing with the money you did not actually pay. It must have some purpose connected with deriving your assessable income.

Most people ignore this last point and have got away with it so far ... maybe because of an unwritten policy of the ATO, who knows ???

Cheers,

Rob

 

Here's the thread... Capitalising Interest- the facts
Steve

 

Thanks for the link yo yo ma, really interesting read...

Is there any ruling from the ATO where they have allowed this sort of plan?
I assume that it is important for the individual investor to specify the purpose of the LOC is to Pay for Expenses incurred on an Income Producing Asset, and the original loan is for the Purchase Of an Income Producing Asset.

I guess it would be worthwhile creating the schematics of my individual plans and circumstances, then spending a few $$$ to run it by an Accountant...

 

You should definitely see your Accountant regardless - remember these forums are public, so you have absolutely no idea about any of the advice/opinions/suggestions/comments of anyone here.
Your accountant can run through it with you, and even go through the process of applying for a private ruling using your own particulars.

 

Mr S asked

You cannot claim 100% of the interest on the IP loan.

The extra $100,000 borrowed and parked in the offset account is private money. It was NOT borrowed to finance any investment at the time but simply place in your private offset account. Therefore only 3/4 of the interest on the $400,000 borrowing can only always be dedutible.

The thread reference posted by yo yo ma sets out the preferred strategy to fund investments by debt & fund personal expenses by investment income.

Also here is a link to ATO ruling TR 98/22 on linked & split loan funding where tax advantages & Part IVA implications are discussed that disallow interest deductions.

TR 98/22 - Income tax: the taxation consequences for taxpayers entering into certain linked or split loan facilities (Current for 16 December 1998 to 10 August 2004)