Tax Tip 104: Interest in Advance and Tax Issues

Tax Tip: Interest in Advance and Tax Issues


Prepaying interest in advance is a tax strategy used to bring forward expenses to an earlier tax year. People may want to do this so that they have greater deductions to offset an unusually high income and/or they may be predicting a low income the next year.


There are various rules about prepaying interest. For a deduction to be claimed you must actually ‘incur’ the expense. Simply plonking a year’s worth of interest in your loan won’t work because usually interest is incurred daily and added to the loan monthly.


Variable loan rates vary (naturally!) so you would need to fix the loan to be able to pay the interest. This needs to be done before the 30th of June and fixing is a bit of a process so don’t leave it till the last minute to do. Westpac have just sent out an email today about prepaying and it is only March.


Interest is generally deductible under s8-1 ITAA97, but the application of section 82KZM of the ITAA 1936 must be considered. S 82KZM relates to small business entities and individuals incurring non-business expenditure. Basically this section limits the proportion of the deduction allowed where the ‘eligible service period’ is longer than 12 months and means the maximum you can prepay and claim in full is 12 months.


Some Consequences

Bringing forward deductions doesn’t reduce or increase your tax deductions but just changes the year in which they are incurred. This can mean the following year you will have less to deduct and this in turn will mean a higher income and more tax than usual that year.


So prepaying can lead to the need to prepay again next year and it can be a vicious circle of constantly prepaying to avoid a year with little deductions. So don’t do this lightly without tax advice.


Fixing rates can mean you will be paying a high rate if the variable rates drop during the fixed period. It can also mean higher exit fees if you wish or need to sell or move lenders. So seek advice from your mortgage broker on this aspect.



Summary

Prepaying interest for 12 months or less will mean any deduction is incurred at the date of prepayment.


Seek specific advice from your tax advisor and mortgage broker for the lending side.


Legislation:

Section 82KZM of the ITAA 1936 INCOME TAX ASSESSMENT ACT 1936 - SECT 82KZM Expenditure by small business entities and individuals incurring non-business expenditure


Section 8-1 of the ITAA 1997 INCOME TAX ASSESSMENT ACT 1997 - SECT 8.1 General deductions

 

Yes - Many people forget in a future year and then face a year without any interest deduction.

Prepayment can be a very good strategy when large unexpected income occurs in a year eg a substantial capital gain or non-recurring income. The benefit of prepaying can bring forward a deduction and then that extra income is taxed at a lower marginal rate. Perhaps also saving budget deficit tax, Div 293 tax or other tax ??)

Definitely one for careful calcs and advice.