Tax deductibility of capitalising interest

Hello everyone,

I am new to this forum and would like to know the answers to the following questions.

Suppose I set up a line of credit (LOC) against the existing equity in my PPOR. I use this LOC solely to fund the shortfalls in my negatively-geared investment property. I understand the actual shortfall is tax-deductible. But is the interest charged to the LOC also tax-deductible?

Also, if I use the one LOC to fund the shortfalls in several negatively-geared IPs and nothing else, does this complicate things when doing my tax-return? Or can the accountant sort that kind of thing out easily?

Lastly, who would be a good person to see in Melbourne (western/northern suburbs or city) to arrange a unit trust-hybrid trust setup for property investing? And who would be a good mortgage broker who could arrange finance for the trust?

Any answers would be greatly appreciated.

DonG

 

Don,
As far as I know the interest charged on the LOC is only tax deductible when used for investment purposes ie to produce an income.
Why not invest the LOC funds instead into an income fund or high yielding shares? You could then use this income to fund the shortfall on your IP's and the LOC interest would then be deductible.
Cheers,
Lorrimer

 

I am not an accountant but in my opinion it is tax deductible because we are entitled to borrow and fund a shortfall in any business and IP's are our business.
If you get audited though, you could be asked to explain why you are borrowing to fund the shortfall. My excuse would be because I have too many other expenses and I won' be able to hold the IP if I didn't borrow.
And I am hoping that in the long run the capital gain will be higher than my losses.

As long as you keep all records it shouldn't be hard for your accountant to separate the expenses and allocate them to each IP.
This takes time though and your tax return bill will increase.
An alternative would be to do this yourself.
i.e you group the expenses per IP
for example, if you had 3 IPs and a total of $80K of expenses and total yearly interest of $8K
and your expenditure was
IP1 = $12K/80K =15%
IP2 = $24K/80K =30%
IP3= $44K/80K = 55%

you then allocate
15% of the yearly interest to IP1,
30% to IP2
etc

It's important to keep good records though,
Print out the LOC statements and attach copies of all receipts, group those per IP and I believe you are required to keep them for 7 years.

 

TD 2008/27

Capitalising is regarded as a new borrowing.

Accordingly it does not follow the purpose of the original funds.

You must demonstrate that the new funds borrowed was used for earning your assessable income.

Then we get into arguments with the ATO about subjective purpose since we cannot trace the actual use of the additional funds, plus the funds that we would otherwise have used but for the borrowing !

e.g. "I didn't make that rates payment from the rental receipts (I capitalised) this period because I needed the money for a holiday."

e.g. "I didn't make the rates payment from the rental receipts (I capitalised) this period because I had *ADDITIONAL* expenses of repairing a property and the shortfall would otherwise have forced me to cancel my holiday."

Cheers,

Rob

 

Rob

I've read throughTaxation Determination TD 2008/27
TD 2008/27 - Income tax: is the deductibility of compound interest determined according to the same principles as the deductibility of other interest? (As at 3 December 2008)
and I can't see where you got this information from.

It seems to me that there is no separation of ordinary interest from compound interest

30. There is no reason in principle why there should be any difference between ordinary interest and compound interest. Both are simply the cost of the funds which are borrowed. It is artificial to treat compound interest as the cost of some new fund divorced from the original borrowing. The compounding of interest is no more than a formula for computing the interest to be paid on the funds originally borrowed. Accordingly, as the learned primary Judge held, the compound interest, like the ordinary interest, will take its character from the use to which the original funds borrowed are put2.

cheers

 

You have quoted out of context by missing the preceding paragraph (#10).

The statement you quoted is a rebuttal of the presumption that each time you DON'T pay the interest due (i.e. capitalise) you can rely on the "original purpose of the borrowing". A common misconception.

In other words you must apply ordinary interest deductibility principles the decision to capitalise, and not assume it is OK because of the loan's origins.

Cheers,

Rob

 

Rob



I've read the article and I understand that the ATO want to argue the point but where does it state that Capitalising is regarded as new borrowings?

 

To elect to capitalise is a new decision to draw more funds.

Based on the "use test" or "purpose test" these new funds are not necessarily for the same use or purpose as the original loan principle and interest.

The ruling states that you must apply general interest principles to this new component and not merely stamp it with the same character as the original amounts.

s.8-1 ITAA97, as far as investors are concerned, requires that the new interest was incurred in gaining or producing your assessable income.

So show decision to defer payment was part of your income producing activity. This is difficult where there is no clear tracing of the funds otherwise used.

Cheers,

Rob

 

Rob

ok understood, but my decision to capitalise the interest would be because I can't afford to support the IP loan or I am not willing to do it because I feel that my money would be better invested in something else, eg my super, shares etc.

Therefore IMO the ATO cannot tell me to use my own money to cover the shortfall just like they don't do it when you are running a business.

Also, the ATO cannot decide for me if I need to have a holiday or not.
I am the one who knows my stress level and I am the one responsible for making that decision.

cheers

 

No worries Bill.

The Commissioner does not seek to apply Fletcher's case to negative geared investments based on the argument that the long term capital gains make up for the short-term revenue losses. (Note also that expenses designed to merely derive a capital gain are NOT deductible though - ha ha).

However, if somebody purchases an investment and then throughout ownership borrows and capitalises all expenses while using all income for private purposes has undermined this argument if it unreasonable that this plan could ever result in a profit.

Until the ATO comes out with a specific ruling, we all have to guess the boundary. Everybody's comfort zone will be different.

Cheers,

Rob

 

Rob

Certainly if all rental income is syphoned off to pay for holidays and the full operating cost of the IP is funded by additional borrowings then it may be hard to justify.

But if all rental proceeds are directed toward operating expenses of the IP, and the LOC is only used to meet the actual cashflow shortfall of owning the IP, then I would have thought one would be on pretty safe ground?

In the current financial environment, if the ATO starts dissallowing companies from claiming interest deductability on new borrowings to meet current cashflow shortfalls they are going to be very busy indeed.!!

 

Only investors seem to be scrutinised so heavily.

Cheers,

Rob