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Capitalising Interest

On the 29th June the ATO issued a draft ruling regarding using rent to pay off your home loan sooner. TD 2011/D8 discussed arrangements where interest is capitalised on a rental property loan while the rent is used to reduce the principle on the non deductible debt on the private home.

This Ruling May Come as a Shock for some Investors

This ruling may come as a shock for some investors who have paid many thousands of dollars to finance brokers and property spruikers for such an arrangement. It certainly makes us feel a lot better about our conservative, get a private ruling approach.

This ruling is only a draft and there will be many submissions by the profession because it goes way too far and ignores established case law. Nevertheless, it makes some very reasonable points.

Background Information on Capitalised Interest

Capitalised interest is only deductible if it is not part of a scheme

Firstly a bit of background information. Capitalised interest is only deductible if it is not part of a scheme with the dominant purpose of a tax benefit (Part IVA). There have been a few private rulings allowed by the ATO where taxpayers were successful in arguing their dominant purpose was simply to pay their home off sooner or that they should not be required to use private funds to prop up an investment.

Exclusively covers argument that the dominant purpose was to pay their home off sooner

The draft ruling specifically and exclusively covers the argument that the dominant purpose was simply to pay their home off sooner. Of particular interest is a point that surprisingly has not been used before by the ATO. That, if the overall debt of the taxpayer remains the same then they are not really achieving their desired result. Of course the overall debt doesn't remain the same, it should reduce by that nice fat tax refund cheque but we are not too sure whether that is a good line to argue, considering we are saying the dominant purpose is not a tax benefit.

Ruling Goes Too Far

The ruling does go too far in implying that you must use your wages etc to prop up your investment possibly leading to borrowing for private expenses instead. It also claims to apply retrospectively which is unreasonable considering the number of rulings and case law it contradicts. Accordingly, we do not expect to see the final ruling taking this form and are aware of many submissions that will be made against it. A copy of our submission is available in the menu above.

Applying For a Ruling of Your Own

So where to now? Don't let this prevent you from applying for a ruling if you feel you have another suitable argument that is not based on paying your home off sooner. Examples maybe that you have high home loan repayments (the term of your home loan maybe 10 years) and didn't get the pay increase you expected or spouse has to take time off work etc.; so you cannot afford to meet all your commitments and need to use the rent for private purposes just to get by. There are many precedents that mean the ATO would loath to try to tell you how you should manage your money.

Also consider simple laziness. You have a line of credit where the interest payments for the rental properties are paid from so that you don't have to keep track of your accounts to make sure there is enough money to cover the mortgage repayments of course you don't have the rental property payments drawn from your home loan or offset account because that would make it a mixed purpose loan. Just be open and honest with the ATO and explain that this seemed a reasonable method of keeping your affairs simple and ask them just what they require you to do for the interest on the LOC to be fully deductible. They cannot tell you how to manage your finances so they will have difficulty answering your question. This is why TD 2011/D8 is so vague in that regard and just claims an amount that might reasonably be expected.

An Individual Taxpayer has a Far Greater Chance of Success

It is our opinion that a ruling application made by an individual taxpayer has a far greater chance of success, when it comes to floodgate claims, than one made by a professional. This part of our web site is dedicated to assisting you in preparing your own private ruling application. Please utilise the partially completed ruling application for in the menu above and add your own particular circumstances. If you have any concerns about your application any of our offices will be happy to review it for you at our normal hourly rate. Then you can still lodge it in your own name.

When Capitalised Interest is Allowed

Here are the basics on when capitalised interest is allowed that we learned from the Harts cases:

  1. Capitalised interest takes on the nature or the original borrowings - if the interest on the original loan is deductible then you can claim interest on borrowings to pay the original interest

  2. If you can't afford to make an interest repayment and have to borrow it (ie allow the loan balance to increase because you have available credit) then interest on that borrowing is tax deductible

  3. If you enter into an arrangement to capitalize interest with the dominant purpose of achieving a tax benefit then the interest on the interest is not tax deductible because it is caught by Part IVA a scheme with the dominant purpose of a tax benefit. In Harts case the ATO simply had to produce bank advertising material saying there was a tax benefit in the loan.

Some Interesting ATO Responses

Note that PBRs are private binding rulings so cannot be enforced upon the ATO by anyone other than the rulee, nevertheless here are some interesting ATO responses:

  • PBR 69725 - An investment in shares where the taxpayer said he or she did not want to use other wages income to prop up the cash shortfall in the investment. The ATO said they could borrow the shortfall instead and that interest on interest would be deductible. No mention was made of the use to which the dividends were put. If the ATO thought they could require the taxpayer to use the dividend to pay off the loan or interest then it certainly would have. There are many case precedents where the ATO has not been allowed to tell a person how they should manage their affairs.

  • PBR 81797 - Accepted dominant purpose was not a tax benefit but simply quarantining a rental property expense, so Part IVA did not apply.

  • PBR 94265 - ATO accepted that the dominant purpose was to own their home sooner, not a tax benefit, so Part IVA did not apply

  • PBR 1011345133229 - ATO considers the arrangement is caught by Part IVA because just like Hart's case the loans are linked. The ATO claims the loans are linked because they share the same security.

Lender Promoting Tax Benefits

Based on the above if you do have another dominant reason other than the tax benefit or owning your own home sooner you should apply for a ruling and take care that your LOC, where the interest is capitalized, is not secured against the private home. This can be achieved by using all the equity in the home as a deposit for a rental property and then having spare equity in the rental property to secure the LOC where interest is capitalized and rental expenses are paid. It is best to keep this LOC separate from the loan to actually buy the rental property just in case everything goes pear shaped, at least you have not tarnished the loan where interest is clearly deductible. Also make sure you don't enter into your arrangement with a lender that is promoting the tax benefits or that it is a way to own your home sooner.