All Topics / Legal & Accounting / Deductibility of interest on interest accrued

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  • Profile photo of KateAKateA
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    @katea
    Join Date: 2002
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    Hello

    If I stop paying interest on my IP mortgage is the interest on the interest accrued deductible?

    I have been searching the ATO databases re this one but I’m still not sure. I would be very grateful if anyone has a definitive answer on this or knows of any relevant rulings or cases.

    Regards
    Kate

    Profile photo of melbearmelbear
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    @melbear
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    It probably would depend why you stopped paying.

    I must admit, your comment concerns me. Why will you stop paying?

    If it’s so that you can pay off your PPOR the ATO will take a very dim view of it. That is what they expressly disallow.

    Cheers
    Mel

    Profile photo of Mortgage HunterMortgage Hunter
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    I think you will find that whilst this is currently accepted by the ATO it is still in the High Court atm.

    I think the issue is the capitalising of interest.

    Some folks allow an IP loan to capitalise while they use two sets of repayments to pay out the PPOR (non-deductible debt). This is called split loans and is under legal action.

    Sorry I cannot be more definate but it is a dicey area and not a course I would embark upon without some professional advice.

    Cheers,

    Simon Macks
    Mortgage Broker
    [email protected]
    0425 228 985

    Comments may not be relevant to individual circumstances. If you intend making any investment, financial or taxation decision you should consult a professional adviser.

    Profile photo of melbearmelbear
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    @melbear
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    Simon, I thought that the ATO was still not accepting the practice, even though they lost the last battle? Pending resolution of the final one?

    Cheers
    Mel

    Profile photo of Mortgage HunterMortgage Hunter
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    You are probably right Mel. I haven’t been following it closely.

    Either way it is something I advise against.

    Cheers,

    Simon Macks
    Mortgage Broker
    [email protected]
    0425 228 985

    Comments may not be relevant to individual circumstances. If you intend making any investment, financial or taxation decision you should consult a professional adviser.

    Profile photo of KateAKateA
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    @katea
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    Thanks heaps for your help Mel and Simon.

    The reason why I wanted to do this is because we have had significant growth on our IP and consequently we now have quite a large amount of equity. We owe about $15k on our PPOR which I want to eradicate but now that we are paying school fees it seems like it is going to take forever (it’s kind of like the last few kg when you’ve already lost a lot of weight). We’ve worked really hard to get our home loan to where it is but the last little bit is going to prove the hardest. I remembered that way back when I first found this site there was a news section that was following the ATO’s position on this issue. Do you know what the relevant cases or rulings are?

    Thanks again

    Kate

    Profile photo of Mortgage HunterMortgage Hunter
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    http://www.somersoft.com/forums/search.php?s=&action=showresults&searchid=211553&sortby=lastpost&sortorder=descending

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    Cheers,

    Simon Macks
    Mortgage Broker
    [email protected]
    0425 228 985

    Comments may not be relevant to individual circumstances. If you intend making any investment, financial or taxation decision you should consult a professional adviser.

    Profile photo of KateAKateA
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    @katea
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    Thanks Simon, that is really very helpful.

    Kate

    Profile photo of JuliaJulia
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    @julia
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    Kate A
    The following is an extract from an article I wrote on the subject.
    The score card so far:
    1998 – ATO issues ruling TR98/22 claiming that the only purpose for capitalising the interest was to reduce the debt on the private residence so the interest on the capitalised interest was a cost of the private mortgage not the rental property mortgage therefore not deductible. This is a subjective interpretation.
    2001 – Single member of the Federal Court, Gyles, J. decided “… the arrangement was to take advantage of the tax benefits (i.e. the deductibility of all the interest). It therefore followed that Part IVA applied to the scheme”.
    2002 – Full bench of the Federal Court decided in Hart & Anor V FC of T 29th July 2002 that “the dominant purpose of the scheme was the obtaining of funds, so the scheme was directed to a commercial end – the borrowing of money for use in financing and refinancing the two properties. Accordingly, Part IVA did not apply”.
    Appealed by the ATO to the High Court yet to be decided.
    It is probably inappropriate for us to offer our opinion on this case as we are accountants not lawyers but nevertheless we are encouraged as the findings of the court in this case could not have been more favourable.
    Of course our rental property handout (booklet) has been updated with the findings of Harts case but stay tuned as the ATO has appealed so we cannot recommend relying on this just yet.
    In the mean time, it may not be worth the cost of entering into the above loan facilities unless there is a cheaper interest rate offered. Note: If so, this will further support your deduction as the dominant purpose was not the tax benefit but a cheaper interest rate. But if you are arranging finance it may be worth considering one of these loan arrangements as you have nothing to lose. If the appeal turns in your favour, you have already made considerable mileage with your capitalised interest. If it works against you the capitalised interest is not deductible but it has not cost you anything extra to enter into an arrangement that gave you an each way bet. If you are already in one of these arrangements there is no need to bail out yet but consider holding off claiming the interest on the capitalised interest until the issue has finished its full run of the courts.
    Note it is not necessary to pay a finance broker to put you into one of these loans, they can be arranged by Don Sutherland through our office with no extra costs than the normal bank establishment fees.
    In the 2001 case where the taxpayer lost, the Judge still said that the capitalised interest bore the same characteristics as the simple interest and was therefore deductible but decided that the whole arrangement was a scheme to reduce tax and so caught by Part IVA. This point is worth considering if you are arranging finance, you would have a better chance of not being caught by Part IVA if you do not use one of the loans package for that purpose. For example you could organise two different loans with two different banks. One would have to accept only second mortgage status on your home loan but if you have enough equity it should work. One of the banks loan you more than you need to borrow for the rental property and you use this up by capitalising the interest. Occasionally you may need to refinance the loan to shift more of your equity from the first mortgagee to the second mortgagee. This is just an idea not a guarantee it will work if challenged in the courts it is still wait and see on this topic.

    In Harts V Commissioner of Taxation 2001 FCA 1547. The court found that it was an arrangement that the taxpayer would not have entered into if it was not for the tax advantage, so is caught by Part IVA. Interestingly, the court did not agree with the ATO’s argument that capitalized interest is not deductible. The concept is worth considering. It is not for the Commissioner to tell you how to organise your affairs but if you enter into a scheme with the dominant purpose of a tax benefit then he can disallow the advantage sort. If you have two separate loans with two separate banks and one is an overdraft facility for the rental property there is no law requiring you to use the rental money to pay off the overdraft. But you should not have entered into the facility with the dominant purpose of a tax benefit. The loan can be interest only and be drawn on for repairs etc. Similarly, if your business as a sole trader operates on an overdraft you are not compelled to use the business income to reduce the overdraft. It can pay off your own home loan instead. Note none of the above should be read as a way to ensure a deduction. This is simply a discussion of the issues. In fact CCH are of the opinion Part IVA is wide enough for the ATO to consider using it against arrangements like the above. But there must be a line where they can’t call it on arrangement but just normal business transactions. In other words be discrete. The law is unsettled, no one can advise with certainty until the matter goes before the courts.

    [email protected]

    Profile photo of Mortgage HunterMortgage Hunter
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    Note it is not necessary to pay a finance broker to put you into one of these loans, they can be arranged by Don Sutherland through our office with no extra costs than the normal bank establishment fees.

    Few brokers charge a commission these days Julia. Certainly none of the folks who post mortgage advice here do so as far as I am aware.

    Simon Macks
    Mortgage Broker
    [email protected]
    0425 228 985

    Comments may not be relevant to individual circumstances. If you intend making any investment, financial or taxation decision you should consult a professional adviser.

    Profile photo of Still in SchoolStill in School
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    @still-in-school
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    Hi Julia,

    1998 – ATO issues ruling TR98/22 claiming that the only purpose for capitalising the interest was to reduce the debt on the private residence so the interest on the capitalised interest was a cost of the private mortgage not the rental property mortgage therefore not deductible. This is a subjective interpretation.

    Just looking at notes, the TR98/22 Income Tax – (the taxation consequences for tax payers entering into certain linked or split loan facilities.)

    Isnt that still going under some sort of ruling still with the High Court? or has that been ruled now?

    sorry just a bit confused now.

    Cheers,
    sis

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    Profile photo of melbearmelbear
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    @melbear
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    Yep SIS, it’s still being argued. I reckon even if the taxpayer wins the argument, there will be legislation introduced pretty quickly that disallows the whole concept.

    Cheers
    Mel

    Profile photo of KateAKateA
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    @katea
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    Thanks everyone for your comments.

    If the issue is still being argued and I go ahead with this but then the taxpayer loses the case will that mean that I am liable retrospectively for the deductions that I have claimed? Or if I go ahead and say in 6 months legislation is introduced to outlaw the deduction will I be liable retrospectively or only from the date the legislation is introduced? I know these are hypotheticals but I’m just trying to get a handle on the level of risk that I would be taking if I went ahead.

    Cheers (it’s wine o’clock)
    Kate

    Profile photo of wrappackwrappack
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    @wrappack
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    KateA, if you were intending to set up a split loan and PPOR loan (or already have) and use your theory, I think that you would be on very shaky ground. My vote goes with Mel, if the ATO loses, they will get parliment to bring in a law that says that interest on interest is not deductible. Probably wouldnt be retrospective though.

    In your case, lets crunch some numbers and see if it is worth worrying about. If you owe 15K on PPOR, interest is about 7%=1050dollars a year. At top marginal rate if you could shift this to the IP, you might end up saving 500 bucks a year. If you get audited, and your auditor sends you a bill, is that really going to do you damage? However, if you did it over a few years on a new 500k loan, well you could be heading for the bankruptcy court.

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