Legal Tip 15: An issue with mixed purpose loans where both portions are investment.

An issue with mixed purpose loans where both portions are investment.

Tax law time.


Most readers will know the dangers of mixing loans – partial used for investment and partial for private purposes. But there is also a potential problem with mixing 2 or more investment purposes in the one loan account.


An example of a problem with mixing loan purposes.

Tom has a $500,000 investment loan which was used to buy 123 Smith St.

Later he taps into the equity of this property and borrows another $400,000 also secured against 123 Smith St and he buys 456 Jones St. His broker tells him to take the $400,000 by just increasing the $500,000 loan to $900,000. “It’s all deductible after all”.


The interest on the loan will be added once per month and comes in one amount so Tom needs to apportion it between Smith St and Jones St when he does his tax return. This is easy to do. Smith is 5/9 x the interest incurred and Jones is 4/9 x the interest incurred.


Great Tom thinks I am saving $9 per month in account keeping fees by having 1 loan instead of 2.


Later Tom sells Jones Street and receives a large sum of money. The $400,000 loan is not secured by Jones St so there is no compulsion to repay the loan. Tom thinks he can keep it open and still claim the interest – but he cannot because there is no income associated with that interest he incurs. So after seeking advice Tom decides he will use $400,000 cash to repay the loan. (doesn’t matter if he does this at settlement of after).


Tom plunks $400,000 into the loan and thinks it is all done with. He has paid off the debt associated with the $400k borrowed to use as the deposit for Jones St. A year later he is audited and the ATO deny the claim on interest of the $500,000 loan. Why!


Because the original loan is a mixed purpose loan. There are 2 sub loans in the one loan and they are no segregated. So when Tom deposits $400,000 it must come off the 2 portions of the loan in an amount related to their portion.

$400,000 x 4/9 = $177,777 (i.e. the $400k loan is 4/9ths of the total $900k loan)

$400,000 x 5/9= $222,222

$177,777 of the deposit will come off the $400,000 portion and $222,222 will come off the $500,000 portion.


Imagine you have a bottle with milk and orange juice mixed. If you withdraw say 400ml you cannot choose to withdraw just milk as the solution is mixed. Same thing applies here.


Going forward Tom will have a loan balance of $500,000 but will only be able to claim the interest on $277,778 of this loan.

Tom’s desire to save $9 per month has cost him dearly. $222.222 x 5% =$11,111 in lost deductions each year. If he is on the 47% tax rate this would be approx. $5,222 in lost cash per year for the life he owns the property.


Imagine if you have $5,222 extra you could use to pay off your non deductible home loan each year. Imagine the compounding effect.

 

Great post!

A quick question, does a similar approach apply if i but a house and then subdivide the land? When i receive the proceeds from sale of the new titled lot (i am keeping the house) can i just apply the cost base amount against the loan and take the profit or am i effectively trying to pay down a mixed use loan?

 

Same principles apply as it will be one loan with mixed purpose.

 

There goes my dream of paying off my PPOR!

Thanks for the reply @Terry_w

 

Yes this is common with people sub-dividing. The common belief is that you can end up with a big loan on 1 property and no loan on the other, and then live in the one with no loan. You could do this but the interest on the other won't be deductible in full because a large chunk of the loan is associated with the one you are living in.

See my other post with Albanga about this topic. His is more complicated because they are going to change ownership as well as sub-divide.

 

The property is an IP. Currently rented while we subdivide. The plan is to sell the new block and the existing house will remain as a long term IP. My plan was to pay down the cost base of the new block against the original loan used to buy the total property and then pay the profit portion against my separate PPOR.

What about the tax liability created by the sale of the lot, can that be withheld or redrawn from the proceeds of the sale of the lot or redrawn from the IP loan? The property is in my wifes name and will be her only source of income for the year.

 

You will need to apportion the loans between the 2 properties and do this before you sell. Once 1 is sold the loan associated with this property can no longer be claimed. its up to you what you do with the proceeds.

You cannot borrow to pay tax and claim the interest.

 

Hi Terry,

I've done a subdiv about a year ago and haven't sold either blocks.

Original price $420k. loan approx $378k

After subdiv, values are $380k for existing house and land, $210k for new block.

Simplistically, is the loan apportionment done on end value? So the house portion should have 64% of the loan and the land portion should have 36%?

Or is it figured out another way? I might need to split off part of my current loan.

 

Hi Jess

Roughly.

You have to try to get the portions associated with each block right. It may not work out exactly like that because there may be expenses associated with one particular block - e.g if one is land and there are costs associated with the house then the house portion may be a bigger loan.

You just have to work it out on a reasonable basis.

 

How does this work with shares (assuming they pay dividends)? The same way?

Brian borrows (secured against property - so not margin lending) $100k and buys 10 different stocks at $10k each. He sells out of two holdings and repays $20k - does future interest need to be apportioned as per your example?

The solution to your example is split or separate loans, pretty easy with the amounts involved and infrequent trading of housing. It's a lot more difficult in my example requiring ten splits (would a bank even do this particularly considering the small amounts?). Chuck in churn of a stock portfolio and it becomes quite messy. Is there an easy solution in my example?

 

Good question Ed. it would be the same. If you had bought 5 lots of shares for $20k each and then sold one lot paying $20k into the loan would come off all 5 lots.

 

What about with something like the St George portfolio loan, where you have one big fat loan secured by lots of properties? Surely this would create a mess then too - it's the same principle. And margin loans too for that matter?

 

Where the loans can be segregated it should be ok. I think the porfolio loan can have unlimited sub accounts so would be a good option for something like this. Splits can easily be changed too.

Same principles would apply to any loan.

 

Just wanted to thank for your time and efforts to advise/assist others lacking the knowledge/experience you do Terry.

You were one of the first who responded/assisted to my initial noob queries on SS.

Jess above, a local and efficient aid for my requirements, even taking late evening calls, advised I read some of your legal threads for better understandings of current prospects. Takes a bit to get my noob head around it but its always difficult to educate noob style from an experienced mind.

Regardless your an asset to the community, thank you

 

Wow, thanks Terry. I'd never really considered it but it's pretty obvious now that you point it out. I've always been so careful about mixing personal purposes with investment, I can't believe this didn't occur to me

So if I have a messy joint purpose loan at the moment (part for IP1, part for IP2 and part for IP3).. can I restructure finances and split it into three based on purpose proportions, so that if I do sell one of them I can pay off the full amount related to it? Or is it too late since they're already combined and any new loans from a refinance would continue to have same proportions?

 

As long as the loans are IO then there is nothing really to worry about until you sell one. When you are applying for further finance it wouldn't hurt to restructure at the same time.

 

Here is another version of the mixed loan problem.

Tom has 2 investment properties
Property A purchased for $500,000 with a loan of $400,000
Property B purchased for $600,000 with a loan of $400,000 secured against Property B and another $200,000 secured by property A.

Later Tom wants to sell property A for $800,000. Loans secured by property A are $400,000 (used to purchase property A) and $200,000 (used to purchase property B).

When selling loans must be paid off or the mortgage will not be released and the sale cannot go through.

So Tom thinks he must paid off the $200,000 loan relating to Property B. This will mean he has approx $10,000 less per year to claim in interest. About $6,000 cash loss per year.

Tom then understands he can maintain deductibility by refinancing the $200,000 loan - or just substituting the security. It is now secured by Property A, so all he has to do is to make it secured by Property B and he will be able to keep it open. Luckily Property B has gone up in value so the $600,000 loan it secures will be less than 80%,

But Tom didn't seek advice when setting this up, so he only has one big loan of $600,000 but has notionally been claiming the interest on 2 loan splits of $400,000 and $600,000. That is ok until it comes time to pay off a portion.

If Tom were to move $200,000 of the loan from security A to security B it can't be said he is moving the loan associated with the purchase of property B because it is pooled money and he has a mixed purpose loan.

However the ATO allows people to unscramble eggs. Paragraph 18 of TR 2000/2 allows a mixed purpose loan to be split:

Failure to split before refinancing could result in some complications.

 

When splitting 1 mixed loan into 2 parts, is it ok to keep one part of the spilt on an existing loan account number, or should both parts get new account numbers to qualify?

 

Good question. There is no clear answer out there, but it would appear that the requirement is to split the mixed loans on a reasonable basis. cutting off a portion of an existing loan may qualify for this - but seek your own tax advice.

 

The refinance principles don't care about account numbers. Tracing prevails. If its disputed YOU must have a defencible position