Tax matters Part 2 – Interesting mortgage facility considerations
There are numerous considerations when it comes to establishing a mortgage with which to purchase an investment property. Do you opt for all the bells and whistles offered by the bank and will you be required to pay early exit fees? Will you be afforded the capacity to redraw any extra funds paid into your loan or offset another account and save interest?
You might think that these are questions that can be answered on the fly, but the fact is, how you structure your borrowings will impact your entire investment journey, including each tax time that comes around.
In this second of our third part, mortgage tax matters series (you can read Part 1 by clicking here), I will walk you through how certain aspects of your mortgage portfolio can impact your tax obligations and entitlements.
Redraw – be careful!
Redraw is the ability to withdraw any extra repayments that you make on a loan, that is, any repayment greater than the required minimum repayment. The ATO treats any redraw as a separate loan and, once again, its deductibility comes back to the purpose test.
For example, if you have a $300,000 investment loan and receive a $20,000 bonus from work (wouldn’t that be nice!), which you intend to use for a holiday at the end of the year, but you park the $20,000 in your investment loan (by making a loan repayment) in the interim to save interest, this will be considered an extra repayment.
If you then redraw that $20,000 at the end of the year to pay for your holiday as planned, the ATO will deem that you now have two loans – one for $280,000 which is still tax deductible and one for $20,000. This latter amount is no longer tax deductible, however, as the loan purpose is to finance a personal holiday, which has no connection with assessable income.
In this sense, you need to be careful about how you use redraw facilities and what you use redraw money for, as it can confuse a loan balance and may end up costing you from a taxation perspective. A very simple solution is to use a loan with an offset and deposit any cash in the offset, instead of the loan account itself.
Don’t mix loans!
If the loan account is for a couple of purposes, such as in the above instance where you have a $280,000 loan and a $20,000 loan, but where the $20,000 is used as a deposit, you need to provide calculations or file notes to indicate why you’ve apportioned the interest charged on that account pursuant to the division of the $280,000 and $20,000.
Because you are reliant on your own records in this instance, it’s generally better to have every loan separated by purpose and asset. This is particularly important if you have shares and property.
If you make principal repayments on a loan that is used for different purposes you must apportion the repayments. Using the above example of the $300,000, if you repaid $2000, you would apportion $1867 (being 93.3% – $280,000/$300,000) of the repayment to the deductible portion ($280,000) and $133 to the non-deductible portion ($20,000).
In other words, you cannot simply nominate that the repayment of $2000 was to repay, say the non-deductible portion only (as there is only one loan). This is a very good reason to split your loans so you have a different account for each purpose and property.
Interest on interest
The question of whether interest on interest (often referred to as capitalised interest) is tax deductible confuses many people, even a lot of accountants!
If you have a $300,000 investment loan at 7% (interest cost $21,000 a year) and instead of using your cash or rent to pay the interest on the loan you decide to use, say a line of credit, you will be charged interest on whatever you use from that line of credit (i.e. the $21,000), hence creating interest on unpaid interest (much like a credit card if you don’t repay in full each month).
Essentially, the verdict that was handed down in the High Court (Harts Case) was that if you enter into this type of arrangement solely to obtain a tax benefit with a split loan rather than two separate loans, it is not deductible. However, the court determined that in general, interest on interest is deductible, which is something few people are aware of.
There are two things you must do to ensure a capitalisation of interest structure will meet the ATO’s guidelines:
- The dominant purpose of entering into the arrangement must not be to obtain a tax benefit, and;
- The loan used to fund the capitalised interest must be a separate loan (not a split loan) that doesn’t require repayments (i.e. a line of credit).
Capitalising interest on investment debt can be quite an effective tax-planning tool for people who have both non-deductible (home loan) and deductible debt (investment loan).
For instance, you could decide not to make any repayments on your deductible debt, plough all your rental and employment income into your non-deductible debt to repay your home loan as quickly as possible and use a line of credit to pay the interest on the investment loan.
By doing so you will end up paying less interest, because you effectively end up paying less tax (as an increasing proportion of interest is tax deductible).
Many people hesitate to buy an investment property until they have repaid their home loan. They have the (somewhat misguided) idea that they should reduce their home loan rather than diverting some of their income to support an investment property. This is more a psychological than fundamental reason as to whether you should start an investment property portfolio.
If this is a homeowner’s primary concern, this type of loan structure is perfect, because it means the investment property isn’t going to be a cash-flow burden. They can still put all income (and even some extra rental income) into their home loan rather than funding an investment property purchase, essentially enjoying the prospect of having their cake and eating it too… interesting don’t you think?
It is critical that this structure is set up properly and with the correct product, so seek professional advice.
Interest only offset
An interest only offset is a type of mortgage product. In fact, it’s really two products that are linked. It involves establishing an everyday transaction account (often referred to as the offset account) and a loan account.
This is probably best explained using an example. Assuming an investor has a $300,000 investment loan and $20,000 of cash savings, he could establish an offset account and link it to the $300,000 loan. He would then deposit the cash in the offset, which means the bank would calculate interest on the net amount, being $280,000 (essentially any cash in the offset offsets the loan balance when the bank calculates interest). The bank would do this calculation at the end of every day to calculate the month’s interest bill.
An offset is a must
What’s the benefit? Let’s again consider the example where the borrower has a $300,000 loan and $20,000 of cash savings. If they have an offset account linked to an interest-only loan, they can deposit that $20,000 in the offset account and because their loan is interest only, their repayments will be calculated on the net balance of the amount in the offset and the amount in the loan, so interest repayments would be calculated on the $280,000.
However the underlying benefit is that their loan balance never changes from the original $300,000. So the borrower can withdraw that $20,000 out of the offset again at the end of the year to spend on his holiday, without altering his ability to claim a deduction on the $300,000 loan balance. The tax-deductible loan balance is therefore preserved.
In this respect, an interest-only offset account is a highly beneficial product from a tax planning perspective, particularly if you have a lot of cash to contribute to an investment property.
For instance, even though you might have enough cash to pay for 50% of the purchase price, you will potentially be better off borrowing 80%, then placing the balance in an offset account. In this way, you still only pay interest on 50% of the property’s value, the difference being that you’ve crystallised a higher tax-deductible loan.
Interest-only offsets are a brilliant solution for many would-be investors and do indeed offer the best of both worlds…something to seriously consider when setting up your finances for the future!
For more information on how you can manage and maximise your proper investment debt and maintain your cashflow, click here to contact us, or subscribe to receive regular post updates and industry insights.
Stuart Wemyss is a chartered accountant and founder of Property Tycoon Finance. Email: firstname.lastname@example.org
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