By directing the rent from your rental properties into your personal home loan and borrowing to pay the interest, rates etc on your rental properties you can reduce the term of your home loan to a fraction of the time with the added advantage that you will then only have tax deductible (good) debt.

If you capitalise interest with the dominant purpose of deriving a tax benefit then Part IVA will allow the ATO to deny you a deduction for the capitalised interest. This approach stems from Hart's case in 2004 where the ATO proved that the taxpayers' dominant purpose in capitalising their interest was a tax benefit because they used a linked loan that was promoted by the banks for its tax benefits.

Capitalised interest occurs when you don't make the interest payments on a loan so in the following month you are charged interest on both the amount borrowed and previous interest that has been added to the loan. This also applies when you borrow from another loan to pay the interest on the first loan. Capitalised interest is deductible if the original interest is deductible.

We have recently received a positive private ruling from the ATO on the question of whether they would consider the dominant purpose to be a tax benefit if rent is used to pay off a home loan. We argued that the dominant purpose was to own the home sooner, the tax benefit was incidental. After all the majority of home owners spend 20 years of their working life with the dominant purpose of paying off their home loan as soon as possible. To argue that obtaining a tax benefit while doing so, changes the dominant purpose would be the same as trying to argue that a person who walked into a newsagency to buy an invoice book should not be able to claim a tax deduction because the act of buying the invoice book incidentally created a tax deduction and that this then overrides the dominant purposes of obtaining the invoice book for the purpose of writing out a bill.

Now the ATO response cannot be relied upon by anyone other than the applicant so you will need to apply for your own ruling. The following issues should be addressed in your ruling application.

The Basic Arrangement
There is a loan for the rental property, a line of credit and a loan for the person's own home. The rental property loan is interest only and the interest payments come out of the line of credit. This line of credit is also used to pay rates, insurance etc on the rental properties but there is no private use. All of the person's income, including tax refund cheque, rent and wages are paid into the home loan though drawings are made from it to pay living expenses. Every few years the loans have to be adjusted. The LOC limit will need increasing to cover the growing tax deductible debt. The bank will be happy to do this by reducing the limit on the home loan which should have decreased by more than the LOC has increased. It is important that the loan is adjusted when necessary rather than having a floating cap. The loans must not be linked in any way, they must all be separate accounts, though they can share security. If the banks offer this arrangement as one of their products, don't touch it. This is something you have to set up on an individual basis or the dominant purpose of entering into the arrangement could change.

The Rental Will Eventually Be Profitable
Interest on a loan for a rental property is still deductible even though the rental property may be making an overall loss, providing the property will eventually become profitable. So the interest is deductible on the basis that one day the taxpayer will derive taxable income from it. If this is not the case then the arguments that brought down hybrids, such as TR 95/33 and Fletchers case, will come into play. Arguing that a profit will one day be made from the capital growth of the property is not enough, this can lead to the ATO arguing that the interest is a capital cost. So the ruling application needs to have projections of expected rent increases. We used API data. The forecast will probably have to be extended beyond the final payment on your home loan debt to the stage when all spare funds are directed of the rental loan so that the interest expenses is reduced.

Would Enter Into The Arrangement Anyway
For the dominant purpose of the arrangement to be to pay off your home loan then you will enter into this arrangement anyway. It is important to direct your ruling question not as to whether you can do this arrangement, of course you can, it is not for the ATO to tell you how you can arrange your affairs. The question you need to ask them is whether, having done this you need to apportion the interest in the LOC on the basis that the capitalised portion is not deductible.

Make Sure They Address Part IVA
If you do not specifically ask the ATO to address the issue of whether Part IVA would apply to the situation, they will not address it. This is the main point. It is not a question of whether capitalised interest is deductible it is a question of whether the ATO would choose to apply Part IVA because it feels that the scheme is a dominant purpose of a tax benefit. Point out that even if you were not entitled to a tax deduction for the capitalised interest you would still enter into the arrangement because it would pay off your home sooner

Its Not A Matter Of Proving Your Intentions
The actual test is would a reasonable person conclude that you did not enter into the scheme for the dominant purpose of a tax benefit.

Nexus
For interest on a loan to be deductible the borrowings must have been used directly for income producing purposes. In Domjan's case the fact she drew money from the loan and put it into her private cheque account to pay a rental property bill, broke the nexus so she was not allowed a tax deduction on the interest on that portion of the loan. Make sure the rent goes directly to your home loan not to the LOC first. You can't pay the rates, insurance etc yourself then reimburse yourself from the LOC.

Warning, lines of credit are dangerous, if you lack self discipline this arrangement could see you deeper in debt because you have extra borrowing capacity.

Do not get distracted from the above points. It is not a case of having a reasonable argument or what sounds fair. It is all about skirting around the various laws and cases relating to the issues even if this seems to be flying a red flag at the ATO. No matter how valid your argument or how sympathetic the ATO may be to your situation they cannot give you a positive ruling unless it is within the law. With the amount of tax savings involved in these arrangements it is well worth the cost of having your application prepared professionally. In simple and well prepared cases BAN TACS can do these ruling applications from as little as $350. There is a checklist available on our web site to help you become a "well prepared case".

The cash flow effect of the above is a spare $5,000 sitting in the superannuation fund which could be used to make capital repayments. Further capital repayments can be funded by deductible superannuation contributions but these will be taxed at 15%. Nevertheless, this is much better than the person's marginal tax rate outside of super.

If the property becomes positively geared before you reach retirement, the applicable tax rate will only be 15% on net rental income and only 10% on capital gains.

Add all this to tax free income and capital gains and pensions once you reach 60 plus the asset protection of a superannuation fund it is very attractive option. Providing your contributions to the super fund are not out of character, your creditors cannot access your super fund's assets in bankruptcy.

The downsides are the lack of liquidity because you cannot borrow against a property twice ie release the equity and bank charges and interest rates are higher.

There are many restrictions on the circumstances under which a super fund can "borrow". The two most important being that the loan must be have limited recourse and that assets of the super fund cannot be used as security. The asset you are borrowing to buy is held in a bare trust for the super fund until the final repayment is made.

By the way the borrowing does not have to be for property it can be any other assets that a super fund is permitted to purchase but note using a limited recourse loan to purchase shares will mean that any extra interest rate charged other than normal housing loan rates will not be deductible under the provisions to catch capital guaranteed loans.

The way the approved loans work is that the lender's only security is the new property, super funds are still not permitted to mortgage their assets. The new property is held in a bare trust for the benefit of the super fund. This is where the limited recourse comes in. The Lender can only recover this property if the super fund defaults. The Lender has no further right of action against the super fund's assets. So the Lender is going to want the super fund to come up with quiet a large deposit for the asset held in the trust and probably charge a higher than normal interest rate. Once the final installment on the loan has been made the asset is transferred to the super fund. It is important that the trust that initially holds the property is a bare trust. Section 106-50 of the CGT Act states that if an asset is held for the benefit of just one beneficiary who can at anytime instruct the trustee to transfer the asset to them then the asset was always an asset of the beneficiary (in this case the super fund) so it is not a CGT event when the asset transfers.

A way around the expensive loans is for the member of the superannuation fund to borrow from the bank under normal conditions and then provide the appropriate non recourse loan to the super fund. The ATO states in Taxpayer Alert 2008/5 that market rates must be charged in these circumstances. So at the moment it appears this arrangement is acceptable though there is concern that section 66 of SISA could prevent a member or his or her associate from being the lender. So if you enter into such an arrangement make sure you are in a position to refinance should things change.

Some banks require the members to give personal guarantees, the ATO has expressed concern about this stating that this could be a guarantee in their capacity as trustee of the SMSF. Regardless, the legislation only permits limited recourse loans so it would seem that if the bank has another recourse in the fund member that it does not fit within the law.

Fortunately St George bank have bought out a very good product, it doesn't push the letter of the law and is priced quiet competitively.

Summary of the important points:
Must Haves

1. An bare trust must be set up to hold the new asset until it is no longer required as security
2. The asset purchased must be of the type permitted to be purchased by SMSFs ie do not purchase domestic rental properties from members or do not breach the in house asset rules
3. The purchase must be within the scope of the investment strategy
4. The SMSF trust deed must allow borrowings in this fashion
5. The sole motive of entering into the transaction must be to provide for the retirement of the SMSF members.
6. The lender of the funds must not have access to any of the superfund's other assets, in the event of default the lender can only take the asset held in the bare trust.
7. If the lender is a member (currently allowed but an area of contention with the ATO) the funds must be lent to the SMSF at market rates, no more or less.

Best avoided or at least get an ATO ruling before going this far.

1. Utilising the equity in an asset held in the bare trust to purchase another property
2. Holding the new asset in something more complex than a bare trust. Need to consider the CGT and stamp duty ramifications.
3. A member lends the funds for the investment. This is currently permitted but can lead to so many problems the government may well have to change the law to prohibit such arrangements.
4. The members of the SMSF or its trustee or the trustee of the bare trust giving personal guarantees to the lender.

There are certainly advantages in having properties in a super fund and certainly the older you get the more attractive it becomes. Heading towards retirement you tend to have more assets and equity than you would want to fully borrow against, so the lack of liquidity does not matter so much. On the other hand the younger taxpayers could get into difficulty and not be able to get to their wealth locked into super, their life is less certain.

It is not necessary to scurry everything away in to a super fund because once people reach age pension age they are allowed a reasonable amount of income, outside super without having to pay tax. The following is a list of possible retirement strategies for property owners that should be considered before embarking on the costs of a SMSF.

Retiree's Tax Thresholds
The Senior Australian's tax offset kicks in when taxpayers reach the qualifying age for the age pension. This offset means that senior Australians can have a much higher income before they have to pay tax or Medicare levy. The following is a list of the thresholds for each year but note for a couple to fully utilize their entitlement they need to have exactly the same income.

Usually property investors approach retirement with no debt on their own home but quite a bit on their rental properties. Here are three possible strategies they will be considering:

1. Selling off some rental properties to reduce the debt. They will have to pay capital gain tax (CGT), though with careful planning could keep the effective tax rate down to 7.5% by putting the proceeds, after the 50% CGT discount, into superannuation. Nevertheless 7.5% of a $200,000 gain is still $15,000. And if the gain is more than this and it is only owned by 2 people they will be over their superannuation contributions limit.
2. Borrowing against the properties to live on. Not for the faint hearted certainly something I wouldn't recommend. They would need to be confident that they will always have enough growing equity to borrow against, leaving the CGT bill to their children. The interest on these borrowings will not be tax deductible so the portfolio may still manage to become taxable later in life when they will need to find a lot of after tax dollars to finance the loan repayments on the non deductible borrowings they have lived off for the last 20 to 30 years. At that stage they may well be forced to sell one anyway. The trouble with selling later rather than sooner they may be too old to qualify for a tax deduction for superannuation contributions. This would happen if they are over 65 and can't pass the work test or over 75 regardless.
3. Cashing in superannuation to pay off the loans. This would only be suitable in very limited circumstances. Rather consideration should be given to how money in superannuation can be rolled into a pension fund where there will be no tax on its earnings or capital gains. Further, the pension it pays will also be tax free once they are over 60. Of course they can't shift the properties into a super fund later because a fund cannot buy domestic properties off its members.
   Taking money from the zero tax environment of a super fund to increase investment income outside of superannuation could lead to, later in life, too much income being earned outside of super where they will be taxable and too old to put it back into the superannuation fund. Rents go up and depreciation claims will go down.

Here are some strategies to take properties into retirement. Examine the portfolio for properties that could fit into the following

Taxable Gain of less than $100,000 after the discount and owned in joint names. This is a great one to sell just after retirement if over 50, though if over 65 you will need to consider the work test of 40 hours in 30 days but still having low enough wages to qualify to claim a tax deduction for personal superannuation contribution.

The Beach shack with a huge capital growth. This could become the home of the retiree. If it is their home when they die the CGT will be ignored because their heirs inherit the property at the market value at date of death. Careful planning can mean that both their original home and the beach house can be inherited at market value at DOD.

The family home could be sold with no CGT liability and the proceeds used to boost super or reduce debt. Moving into a rental property with a large CGT liability will help reduce the CGT payable by their heirs.

A Pre CGT property is the best one for them to sell later in life. It won't lose its pre 1985 status until it passes to heirs and as there would be no CGT on the sale it is perfect for selling when the client is too old to contribute to super. Certainly, the longer it can be held onto the most that is made of the exempt status.

Consider changing the property to commercial. This is something to be done while they are still able to contribute to superannuation. A property that is used solely in a business can be transferred into a superannuation fund. Superannuation law does not specify that it be a commercial building though it should be legally able to be used in a business ie council zoning. The retiree is not required to be the one to operate the business.

Saving Tax on Your Investment Property - The Book

"Every investment property tax-related question you've ever wondered about is answered here and - perhaps more importantly - the ones you didn't think to ask but should have! For property investors who want to refine their strategy for maximum gain, this resourceful handbook will make a great constant companion." Eynas Brodie, Editor, Australian Property Investor magazine.

Combining Noel Whittaker's easy reading style with Julia Hartman's mind numbing attention to detail was a major challenge which ran way over schedule but it is finished, printed, and in the book stores. You can also purchase it online by going to: www.bantacs.com.au/property.php. The cost is $29.95 plus $5.95 postage - tax deductible of course!

Ask BAN TACS

For $59.95 you can have your questions regarding Capital Gains Tax, Rental Properties and Work Related Expenses answered. For your Accountant, we will include ATO references to support our conclusion. Just go to Ask Bantacs.

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