FACT SHEET - Tax Effective Investment Property Loans 1. Strategies to avoid problems with a mixed purpose loan and maximise interest claims Many loans used to acquire a rental property will have redraw facilities attached to them, allowing the borrower(s) to further draw down moneys from the loan to the extent that funds have been repaid over and above the minimum payment obligations. Investors often incorrectly believe that the amounts available to the borrower(s) in the redraw facility represent the investor s private funds which can be redrawn and applied to non-income producing (private) purpose without affecting the interest deductibility of the original borrowing. Unfortunately, this is not the case. Where funds are withdrawn from a loan account (originally used for an income producing purpose) and applied for a non-income producing (private) purpose under the redraw facility attached to the loan, interest on the outstanding loan balance is not automatically deductible. Refer to Domjan v FC of T 2004 ATC 2204 ( Domjan s case ). This fact sheet will briefly address the following two broad planning techniques to help investors avoid the problems associated with a mixed purpose loan (with a re-draw facility) and to maximise interest claims in these circumstances: Using an interest offset account to avoid apportionment of interest; and Re-financing a mixed purpose loan to avoid apportionment of interest by using subaccounts. 2. Using an interest offset account to avoid interest apportionment on mixed purpose loan accounts In Domjan s case, the Administrative Appeals Tribunal ( the Tribunal ) denied a deduction for certain interest expenses that were incurred in respect of a jointly held loan account (originally used to purchase a number of rental properties) because funds were withdrawn for private purposes under the redraw facility attached to the loan. The Tribunal held that each redraw under the redraw facility constituted a new borrowing of funds and, therefore, it was necessary to consider the use to which these funds were put in order to determine whether interest was deductible to the taxpayer. Therefore, where an investor applies original borrowed funds for income producing purposes (e.g., the acquisition of a rental property) but uses a redraw facility for private purposes, the loan account becomes a mixed purpose account, being partially for income producing purposes and non-income producing purposes. As a result, interest needs to be apportioned.
Naturally, this also applies to loan accounts without a redraw facility, which are used for both income producing and private purposes (e.g., a line of credit facility used for business and private purposes). 1.1 Using an interest offset account to avoid apportionment Investors who envisage using a redraw facility (attached to an income producing loan) for private purposes should consider setting up an interest offset account, where possible. An interest offset account is basically a type of deposit account which operates in such a way that there is no entitlement to receive interest on moneys deposited into the account. Instead, interest payable on the corresponding loan account is reduced. An interest offset account can be used so that moneys that will be used for private purposes can be deposited into the interest offset account (e.g., any repayments made on the loan which are over and above that required by the lender) thereby reducing the interest payable on the loan account which can be drawn down when required. In this way, the loan account can be used solely for income producing purposes, in which case, interest incurred on the loan account can be claimed as a deduction in full. EXAMPLE 1 Rental property loan with a redraw facility Matthew and his wife, Sophie, established a $400,000 Bank loan account in joint names containing a standard redraw facility. Matthew and Sophie used the $400,000 loan to finance the acquisition of a rental property in June 2010 (in joint names). The interest expense accruing on the loan account will be deductible to Matthew and Sophie on a 50/50 basis. In January 2011, Matthew received a redundancy payout of $60,000 from his employer and he applied this amount to the loan account. In April 2011, Matthew and Sophie redrew $20,000 on the loan facility and used this amount to pay for an overseas holiday. Based on Domjan s case, the $20,000 redrawn amount constitutes a new borrowing. Therefore, as the redrawn amount was used for private purposes, interest on this portion of the loan balance is not deductible to Matthew and Sophie. Therefore, interest incurred on the loan balance will be apportioned between the private and income producing portions of the loan. What if Matthew deposits the $60,000 into a standard interest offset account and then withdraws the $20,000 from the same account? In these circumstances, the net amount standing to the credit of the interest offset account will have the effect of reducing the amount of interest payable on the loan account. Furthermore, the $20,000 private withdrawal from the interest offset account does not affect the income producing use of the loan account. Therefore, the reduced interest (i.e., reduces as a result of the $40,000 balance in the offset account) incurred on the loan account with continue to be fully deductible to Matthew and Sophie (i.e., without any apportionment).
Rochdale Tip Use an interest offset account when acquiring a new home Using an interest offset account is a particularly useful planning technique where an investor owns an existing home (on which there is a mortgage) and is planning to purchase a new home without selling the existing home (i.e., the existing home will be used as a rental property). In these circumstances, instead of using spare cash to pay off their existing home loan, an investor can deposit spare cash into an interest off-set account (attached to the existing loan) and let it accumulate. These accumulated funds can be later withdrawn and applied to the purchase of the new home. This strategy will allow the investor to retain the borrowings on their existing home so that when this dwelling becomes income-producing, interest deductions are maximised. At the same time, the investor is also able to minimise their private (non-deductible) debt on the new home. 3. Re-financing a mixed purpose loan using sub-accounts avoiding the problems with loan repayments In Domjan s case, they made specific withdrawals from the redraw facility attached to their loan account, and then made repayments back into the loan account shortly after. For example, the investor withdrew $8,000 from the redraw facility of the loan account for private purposes and then used fund from other sources to deposit $8,000 back into the loan account soon after. The investor argues that she was simply replacing the funds she previously withdrew and, therefore, the interest incurred on this portion of the loan should continue to be fully deductible once the non-income producing drawdown was replenished. However, the Tribunal held that the $8,000 repayment of principal must be applied proportionately against each portion of the loan balance and, therefore, could not be applied solely against the private portion of the loan. Therefore, based on the decision in Domjan s case, it is generally not possible to apply the repayment solely against the private portion of the loan account balance. EXAMPLE 2 Making repayments against a mixed purpose loan Gerard and Mary have a $400,000 overdraft account in joint names. They use 75% of the loan funds (i.e., $300,000) to acquire a rental property and 25% (i.e., $100,000) to buy a private boat. The Interest accruing on the account in respect of the $300,000 loan is deductible, as the borrowed funds were jointly used for an income producing purpose. The interest on the $100,000 remaining balance is not deductible as the funds were used for private purposes. Gerard and Mary sell an existing share portfolio (acquired over the years from personal savings) for $50,000, and use the proceeds to make a repayment to their loan account. Based on Domjans s case, as Gerard and Mary s loan account is a mixed purpose account, the $50,000 repayment of principal cannot be applied solely against the private balance of the loan. It must be applied proportionately against the total outstanding balance of the loan, as outlined below (assuming a constant $400,000 loan balance).
Portion of loan Current loan balance Repayment applied New loan balance Rental property $300,000 $37,500 (75%) $262,500 Private boat $100,000 $12,500 (25%) $87,500 $400,000 $50,000 $350,000 Only the interest that accrues on the outstanding loan balance related to the rental property (i.e., $262,500) can be claimed as a tax deduction by Gerard and Mary. Rochdale Tip The exception for borrowed money that is recouped An exception to the above general rule applies where money in a mixed purpose loan account has been applied to a particular use (e.g., the purchase of a private asset or an income producing asset), and that portion of the loan has been recovered (e.g., sale proceeds) can be applied to that part of the loan originally used for that purpose. That is, a repayment in these circumstances is not applied proportionately against each portion of the loan. However, investors should be aware that if an income-producing asset is sold and the proceeds are applied for a private purpose (i.e., rather than to reduce the income-producing portion of the loan), the nexus between the interest expense and income production will be broken. This means that any interest incurred in relation to the former income-producing portion of the loan will cease to be deductible. 3.1 Re-financing a mixed purpose loan by using sub-accounts the solution to the repayment problem As previously noted, it is not generally possible to direct repayments of principal towards only the private portion of a mixed purpose loan as if the amount were a separate debt. However a planning technique that can be used to remedy this problem is to refinance a mixed-purpose debt by borrowing an equivalent amount under two separate loans or sub-accounts. Under current Australian Taxation Office guidelines, provided the sums borrowed under the two separate loans are equal to the respective income producing and non-income producing proportions of the mixed purpose loan, the Australian Taxation Office will accept that the interest accrued on the debt incurred in refinancing the income producing portion of the mixed purpose debt will be fully deductible. Therefore, by refinancing the loan into separate loans or sub-accounts, any principal repayments can be directed to the separate private sub-account. Note that the costs of terminating a loan (e.g., penalty interest, loan discharge fees, etc.) should be considered before refinancing a loan.
EXAMPLE 3 Refinancing a mixed-purpose loan Stan has a mixed purpose line of credit of $900,000 of which $600,000 was used to invest in income-producing property and $300,000 was used to acquire his home. Stan refinances the loan into two separate sub-accounts: the first sub-account has a balance of $600,000 and represents the income-producing loan, whilst the second sub-account has a balance of $300,000 and relates to his home. Following the refinance, Stan receives $50,000 from his uncle s estate. He plans to use this amount to reduce the outstanding balance on the line of credit from $900,000 to $850,000. Can the $50,000 be directed to reducing the private sub-account balance to $250,000? Yes. The Australian Taxation Office accepts that a mixed-purpose loan can be refinanced into two separate subaccounts. After refinancing the loan into separate sub-accounts, Stan can apply the $50,000 to reduce the balance of the private sub-account, thus maximising his interest deductions. Rochdale Tip Establish loan account with sub-accounts from the outset Where an investor intends to use a loan facility for income producing and private purposes, the investor should consider establishing the loan facility with sub-accounts from the outset. In these circumstances, where one sub-account is used exclusively for income producing purposes and another is used exclusively for private purposes, any repayments can be directed towards the private sub-account which will maintain interest deductibility on the entire income producing portion of the loan (i.e., subject to the facts and decision in Hart v FCT [2004] HCA 26, which broadly dealt with a linked or a split loan facility). Furthermore, any income derived from the income-producing assets purchased using the borrowed funds does not have to be applied to the income-producing sub-account, but can be directed towards reducing the balance of the private sub-account.