Line of Credit – Deductability and Purpose

Steve,

What The Borrowed Money Was Used For Determines Deductibility:
Traditionally, the interest is only claimable on a loan where the actual money borrowed is used directly to produce income i.e. buy the income producing property. The Roberts and Smith case of July 1992 has changed this. In this case a firm of solicitors borrowed money to pay the partners back some of the original capital they had invested in the firm. The Commissioner argued, as has been accepted in the past, that the proceeds of the loan were not used to produce income but for the private use of the partners. The Federal Court ruled that such a simple connection is not appropriate – the partners have a right to withdraw their original investment and as a result the business needed to borrow funds to finance the working capital deficit. It was irrelevant that the loaned money was paid directly to the partners, the purpose of the loan was to allow the income producing activity to continue. The tax office issued a ruling on this matter TR95/25. The ruling states the Roberts and Smith case cannot apply to individuals i.e. sole owners of property because technically they cannot owe money to themselves. The ruling goes on to say:
“The refinancing principle” in Roberts and Smith has no application to joint owners of investment property, which are not common law partnerships. The joint owners of an investment property who comprise a sec 6(1) tax law partnership in relation to the property cannot withdraw partnership capital and have no right to the repayment of capital invested in the sense in which those concepts are used in Roberts and Smith. Accordingly, it is inappropriate to describe a business, as a “refinancing of funds employed in a business.”
IT2423 states that people who own less than three rental properties are not in business and therefore not in partnership under general law. This means that couples wealthy enough to be purchasing their third rental property can rent out their home then borrow the money to build themselves a new home and maybe claim the interest on the loan as a tax deduction against the rent earned on their old home. Note there have been a few cases were taxpayers have unsuccessfully tried to argue they are in business. In Cripps V Federal Commissioner of Taxation 1999 AATA 937 the taxpayers owned 14 town houses and other properties at various time. The ATO was successful in arguing they were not in business but the foundation of the ATO’s argument was that they had an agent managing the properties. So it is crucial that you run the properties as a business i.e. fully mange them yourself.
Regarding TR98/22 and linked and split loan facilities. These loans link a loan for the rental home and a loan for the private home together so the bank will permit repayments from both rental and wages income to be paid off the private home loan with the interest on the rental home loan compounding. Accordingly, in a short period of time the mortgage can be shifted from the private home to the rental home. As the rental loan was used to purchase the income producing property and pay interest on that property, technically all the interest on that loan will be deductible. The Commissioner says in TR98/22 this is a scheme with the dominant purpose of reducing tax and he will apply Part IVA to deny a deduction for the interest on the interest. This argument has now been tested in the courts. 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.
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.

Line of Credit Facilities Dangerous
It is dangerous to use a line of credit facility on a rental property loan when you will be drawing funds back out to pay private expenses. Based on the principle that the interest on a loan is tax deductible if the money was borrowed for income producing purposes, the interest on a line of credit could easily become non-deductible within 5 years. For example: A $100,000 loan used solely to purchase a rental property in financed as a line of credit. To pay the loan off sooner the borrower deposits his or her monthly pay of $2,000 into the loan account and lives off his or her credit card which has up to 55 days interest-free on purchases. The Commissioner now considers there to be $98,000 owing on the rental property. In say 45 days when the borrower withdraws $1,000 to pay off his or her credit card the loan will be for $99,000. However, as the extra $1,000 was borrowed to pay a private expense, viz the credit card, now 1/99 or 1% of the interest is not tax deductible.
The next time the borrower puts his or her 2,000 pay packet into the account the Commissioner deems it to be paying only 1/99 off the non-deductible portion i.e. at this point there is $96,020 owing on the house and $980 owing for non-deductible purposes. When, 45 days later, the borrower takes another $1,000 out to pay the credit card, there will $96,000 owing on the house and $1,980 owing for non-deductible purposes so now only 98% of the loan is deductible, etc, etc.
In addition to the loss of deductibility, the accounting fees for calculating the percentage deductible could be high if there are frequent transaction to the account. The ATO has released TR2000/2 which confirms this and as it is just a confirmation of the law is retrospective.
To ensure deductibility and maximise the benefits provided by a line credit you will need an offset account that provides you with $ for $ credit. These are two separate accounts – one a loan and the other a cheque or savings account. Whenever the bank charges you interest on the amount outstanding on your loan they look at the whole amount you owe the bank i.e. your loan less any funds in the savings or cheque account.

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Elves,

Aw give me a break, I’m passionate about tax.

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Wow [] Julia

Mavster, I think you are stuck at the moment. Basically, the money you borrowed to buy the IP was deductible while it was your IP. Now that it is your home, it is not. Any loan that was remaining from that ORIGINALLY drawn to buy your previous PPOR is deductible. Moving the money around as you have now just makes it a nightmare from what I can see, but hasn’t increased your deductibility.

The only way to get around it, as I see it, is to follow Julia’s tips, and you can slowly recover from the non deductible debt.

Or, you could turn your present home back into an IP!

Cheers
Mel