Is this method of capitalising interest for IP loans acceptable?

Hi all,

There is a thread in the Investing Strategies section of the forum which mentions this, but I wanted to bring it into this section to ask the accountants what their opinion is of using the following strategy to help speed up the reduction of non tax deductible PPOR debt (ie. would the ATO have a problem with it?)

The strategy:

1. pay all income including rental income into the PPOR loan
2. use a separate dedicated LOC to pay the monthly interest costs for an IP loan
3. use the same LOC to pay for all maintenance and IP costs each month
3. only use personal funds to pay the interest in the LOC each month

ie. say the interest on the IP loan is $1000 per month and the monthly IP costs are $200. This would mean the LOC is being debited by $1200 every month to cover these expenses. Only the interest in the LOC is being paid for using personal funds (ie. assuming an interest rate of 7.5%, in month 1 only approx $7.50 would be paid using personal funds, leaving the difference of $1192.50 to pay down the PPOR loan).

Obviously the LOC would be increasing by approx $1200 every month (the interest is tax deductible) and the PPOR loan should also be reducing by this amount every month.

I have heard this strategy mentioned by various people, however just wondered what the opinion of the accountants is?

 

Ronan

Is there a separate IP loan that the LOC is paying the interest for?

Cheers

 

BV,

Yes that is correct. There are 3 totally separate loans accounts. The PPOR loan is only secured by the PPOR. The IP loan and the LOC are both secured by the IP.

1. PPOR
2. IP loan
3. LOC

 

Ronan,

My accountant doesn't have a problem with this setup.
Check with yours.
I hope this helps.

Cheers
Bill

 

Hi Ronan
i am generally a little more conservative and prefer to at least see the rent going toward the Investment LOC, however I have not read or seen anything that would go against what you have proposed.
NickM

 

I agree with NickM's caution.

You are still capitalising IP interest whilst diverting funds to pay down private debt. This could be viewed as additional borrowing for a private purpose.

This was an argument used by the Commissioner in Hart's case, unfortunately this issue was not addressed by the court so it might be tested again.

If you could show at least some of the diverted funds or additional borrowing (via capitalised interest) enabled you to purchase further investments then it would make your argument stronger (e.g. incremental growth).

Purely relying on the capital gain (of your IP) argument is a bit weak and open to interpretation. The Commissioner could argue that it only makes financial sense if you factor in the interest savings on your PPOR as well, e.g. using Fletcher's case as a precedent for 'subjective purpose'.

If you argue that capitalising interest is the only way you can acquire cash flow to service an IP, then why are you accelerating repayment of your PPOR ?

Sorry, I am not attacking your method and it is widely used. I am just trying to anticipate any change in the attitude of the Commissioner. He has been bound by the Treasurer's pro-gearing policy for some time, but given the debt exposure criticisms of the current Government I am wondering if this will change.

If you use this method, then check with your Accountant every six months to see if any new information has emerged on this topic.

Cheers,

Rob

 

Rob,
I fail to see the link between an IP support LOC and what you called additional borrowings for private purposes.
Rental income is taxable income and I can choose to spend it as I like.
Cheers.
Bill

 

Hi Bill,

Look at the overall 'scheme'.

Debt recycling seems to be OK.

The overall result is that your investment loan has grown but you have also acquired additional investments.

The mere fact that the way you do it by first paying down the PPOR and redrawing as an investment loan could be a minor and incidental private advantage, provided you could show the primary purpose was to borrow to gain your assessable income.

Where you fail to recycle but merely pay down the PPOR using rental income and capitalising IP interest expenses in the process leaves itself open to question. What was the purpose of the additional borrowing ?

Even with debt recycling, Fletcher's case is still relevant. If you leave out the private advantage of PPOR debt being extinguished, does the overall income investment strategy make financial sense ?

i.e. the investment must stand on its own merits:

IP capital gain - IP cashflow (negative geared) + investment capital gain + investment cashflow - additional (& capitalised) interest = POSITIVE WEALTH

Otherwise the Commissioner might look to the subjective prupose of a non-commercial arrangement. He will look more closely at capitalised interest because it can rapidly spiral out of control and make an investment appear non-commercial in the long term.

Cheers,

Rob

 

Hi Nick,

What if the property is positive cash flow such that the rental income each month is higher than the interest costs + property expenses?

In this case, would it be ok to transfer the surplus each month into the PPOR offset account?

Ronan