Tax Tip 16: Capitalising Interest

Capitalising Interest

Capitalising interest happens if the interest on a loan is not paid when it is incurred but the loan is allowed to increase. The ATO generally refers to it as ‘compound interest’.

“Compound interest is interest that accrues on interest that is unpaid” TD 2008/27 (para 7)

The same rules for the deductibility of ordinary interest apply to capitalised interest. That is if the underlying interest is deductible then the interest on interest would be deductible. This was stated by Justice Hill on the High Court case of Hart a few years ago. It is also confirmed by the ATO in TD 2008/27 (paragraph 1).

This is naturally attractive to investors as interest on investment properties will be deductible and if you borrow to pay the interest on the investment loans the interest on interest will be deductible too. This frees up cash which could be used to pay down the non deductible home loan sooner and builds extra deductions which could also assist with this too.

But the ATO has the power to deny tax deductions (Part IVA) in certain situations such as where there is a scheme with a dominant purpose of increasing tax deductions. The ATO has published TD 2012/1 which states they can deny the deduction and that the reason of ‘paying off the home loan sooner’ is not a reason which would prevent them from denying the deduction.

But there may be legitimate reasons where borrowing to pay interest may be necessary and where the interest may be deductible. The ATO even state “It is also acknowledged that compound interest, in some cases, will be deductible under 'ordinary' provisions. “ (in Ruling Compendium TD 2012/1EC)

When might allowing interest to compound be ok? When the dominant purpose is not to obtain a tax benefit. The major one being:

• Cash flow

A cash flow issue may be caused by

• loss of employment,
• maternity leave,
• Illness,
• unexpected debts,
• retirement

It is essential that you obtain tax advice before doing anything like this.

 

Hi Terry,

Great post as usual. What if the purpose of compounding the interest on IP is to pay off PPoR first?

Would it be better to get a private ruling?

 

It would be a straight out denial I would think.

 

Thanks for the tax tip posts Terry, absolutely fantastic as I have been looking for answers regarding some of these issues. A few points I was hoping to get clarified regarding capitalising interest. I have done a bit of research and just wanted to clarify with yourself if I was on the right track. Will be following up with the accountant of course:

1. Scenario is investment property earns $25,000 and incurs interest and other expenses of $30,000 thus $5,000 shortfall. Is it legal and straight forward for me to capitalise the $5,000 shortfall so I can put that extra $5,000 into the non-deducitble PPOR debt and still claim interest on the $5,000 shortfall?
2. Take this a step further.... Scenario is investment property earns $25,000 and incurs interest and other expenses of $30,000 thus $5,000 shortfall. Is it legal and straight forward for me to divert the full $25,000 rental income into my PPOR capitalise the full $30,000 in expenses then convert that $25,000 that was paid into my PPOR to Interest only with offset and purchase $25,000 worth of shares? This would then result in the full $30,000 in expenses being deductible on the IP all while reducing my PPOR debt by $25,000???

I have tried to read up as much as possible on debt recycling and the whole Part IVA thing but starts to get a little complex for me.... I will be catching up with the accountant soon but wanted to make sure I was on the right track and not make myself look like a fool!

Thanks.

 

Hi Golazo

1. This is captialising interest. What are your reasons for doing this. If it is to divert income to paying down the PPOR then Part IVA can apply to deny the deduction.

2. Same as above. You appear to be borrowing to pay interest.

Also see my tax tip on debt recycling and capitalising interest for non working periods.

 

Well for scenario 1, would it be fair to consider this for cashflow needs? Probably falls outside of the points you listed for cash flow above though..... But if my investment portfolio were at the point that it is eating up too much of my cashflow to live, would this then be acceptable?

For scenario two, i am effectively borrowing to pay interest in order to cashflow my next investment as I am borrowing again to invest in shares. Atleast this is the way i'm looking at it anyway....

I found quite a good video on youtube re. debt recycling but haven't been able to find it since. If I do, ill post it back in here

 

possibly. But if you are paying down the home loan with extra money then you are not suffering a cashflow crisis.

 

Would your wife going down to part time (reduced income of approx 50%) for 6 months to study (in order to gain a higher assessable income later down the track) be a cash flow issue?

 

Yes that may be acceptable because of reduced cash flow. Seek advice before implementing.

 

2 questions on this topic in the event that the ATO decides your capitalising interest wasn't justified (inspired by recent discussion)

1) If an IP loan and associated LOCs (used to capitalise interest) are all lumped together into one new bigger loan while refinancing, does that 'wash away' the evidence of capitalising interest?

2) What retrospective action can the ATO take for capitalised interest unjustifiably claimed in previous years? Or would they just deny the current interest claim?

 

Chylld...The ATO has godlike powers. The ATO can make a determination (correct or incorrect) and issue a Notice under Part IVA and cancel a tax benefit (ie deduction) for the past "X"years. They can easily do this for 2 years and sometimes 4 years. In some cases they can cancel the tax benefit for a unlimited period of time. ie 10 years +. What we think is a OK practice may be construed to be a scheme and the taxpayers must prove otherwise.

If the taxpayer cannot reasonably satisfy the ATO of the apportionment basis they may deny 100%. The ATO wont argue with the % - They either agree or disagree. If the disagree the taxpayer must then object , appeal etc....All very costly and uncertain.

In respect of the first item...Refinancing doesn't "wash away" a problem as such. It just limits its continued concern so that the problem is resolved. The ATO are more likely to accept a taxpayer argument that they noted a likely issue if the practice continued so the loan was refinanced to split the loan into its 2 elements. They would trace back to the original funding and if satisfied then its a closed issue.

 

Its hard to apply Part IVA to a income sided issue. Part IVA allows the ATO to cancel a tax benefit. They cant very well cancel a taxpayers lack of income or future increased income. Not a scheme to plan your own education and income. Its just living life.

However deferring a statutory entitlement (eg paid leave) to a future tax period when income is low may be a scheme and a issue of common law recognition of income being derived / paid in different tax periods. Not a Part IVA issue as much as a scheme to evade perhaps.

 

I have been reading a lot about interest capitalisation lately, and would be keen to hear any thoughts from people in the know on the legitimacy of the following approach.

I understand that it would likely be considered a scheme by the ATO to use interest capitalisation as a tool to pay off PPOR debt faster, but is it acceptable as a strategy for managing cashflow while you are in the acquisition phase of building an investment portfolio?

For example if over a period of several years I make no repayments off the principal of my PPOR, if anything increasing PPOR debt levels to fund expenses, renovations etc while simultaneously capitalising interest via lines of credit on investment property loans. Surplus cash is parked in an offset linked to the PPOR but it is regularly drawn down to fund deposits/other investments.

I see the dominant purpose here being to fund all investment expenses from equity gains while accelerating the saving of cash deposits for future investments, tax benefits are secondary to this?

 

Drawing down deposits from offset accounts would defeat the purpose as you would be increasing the interest on the non deductible home loan.

 

Ok, fair point, drawing down the offset for investment purposes doesn't make sense, but what if it is used for non deductible investments such as renovations to your PPOR.

Say for example you are capitalising interest on investment loans for several years, while simultaneously building funds up in offset. At the end of this period you undertake significant renovations to the PPOR. The PPOR loan amount remains unchanged, you have benefitted from several years of interest compounding and the renovated PPOR could be revalued to access equity for further investment?

 

The ATO looks at the alternative - what would you be doing if you didn't capitalise the interest? You would be using the funds in the offset. There is no need to capitalise in this instance. The only purpose appears to be tax related.

I don't like your chances.

 

Thanks for the feedback Terry, appreciate the response though disappointed with the theme! Back to the drawing board...

 

The hallmarks of a scheme....

 

If I have an investment loan A with $100K debt (it's a top up/equity loan, 5 year interest only ), and associated offset account B with $100K credit. I know I can use the money at offset account B to pay 20% deposit and other fees for IP. My question is: is it legit to repay the interest for the investment loan A? or I must use main residency loan offset money?

 

have you got borrowed money in the offset?