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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Ben,

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.

[email protected]

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]

Hi Corrine,

I can assist you. I have a practice on Bribie Island Road. If you send me your e-mail address I can send you some reading on CGT and Rental properties.

[email protected]

Digger,

I tend to agree with your accountant. Why don’t you apply for an ATO ruling on the matter. You will have a water tight answer in 28 days. The form is available on the ATO web site. You just need to describe the arrangement as you have here. They will ring you if they need more info.
There is too much money at stake. In investing you should eliminate all the risks you can.

Julia

JimboJames,
It is not worth paying a quantity survery unless the property (if residenital) was built after July 1985 as it is the building depreciation that makes it worthwhile. Also Quantity Surveyors are not trained in tax law. The following is an extract from recent article I wrote on the subject:

Before you spend money on a quantity surveyor make sure you have exhausted all other means. The ATO will not permit you to use the quantity surveyor’s report if you can ascertain the original cost by other means. Subsection 262A(4AJA) requires the seller of a property to provide you with the original information. TR97/25, which is available from the ATO web site, is a good reference. You should also find out if the original owner was a spec or owner builder as the building depreciation calculation cannot include their labour or profit. Make sure the quantity surveyor you use is aware of the changes in depreciation rates for plant and equipment since 1st January 2001. These are set out in detail in TR 2000/18C5, for example refrigerators are now to be depreciated over 20 years, carpets 10 years. The ruling covers most items including stuffed crocodiles that are considered to have the same life expectancy as a refrigerator.

Julia

Jan
My e-amil address is [email protected]

Julia

Sushar,

No reason needed for section118-145

Julia

Secret Plans and Clever Tricks – Divorce Rollover Relief
The rollover relief that is available, under section 126-5, to couples facing divorce means that assets can be transferred by one spouse to the other without any CGT consequences. If rollover relief does not apply section 116-30 will deem the transfer to take place at market value which may result in a CGT liability for the transferring spouse. For rollover relief to apply there must be a court order or section 87 maintenance agreement under the Family Law Act, corresponding foreign family law or a state or territory or foreign law relating to defacto marriage breakdowns. This is not an option but an unavoidable consequence unless you transfer the property before the court order. Rollover relief is not available to same sex couples.
When a spouse receives an asset under the rollover relief provisions, he or she receives the asset at the cost base of the spouse giving the asset and the spouse giving the asset is not subject to capital gains tax on the transfer. Or if applicable, the asset will retain its pre CGT status.
It is not always advantageous to utilise the rollover relief but if the arrangement is part of a court order rollover relief is not optional. But not all assets need to be covered by the court order. The idea is to sort through the assets as to what needs rollover relief and what doesn’t.
A very good example of how this relief can be used to your advantage is combining it with the main residence exemption under Division 118 to exempt the property, from CGT, for the whole period of ownership. For example:
B owned a main residence and a rental property at the time of marriage. At all times up until the time of divorce the properties were always used as a main residence and a rental property respectively. An agreement stamped by the court awards the rental property to B’s spouse. B retains the main residence and continues to use it as such. The main residence will be exempt from CGT from the time of purchase right through the divorce up to a time B either sells it or elects not to have it considered his or her main residence. Due to rollover relief B will not be subject to CGT on the disposal of the rental property to his or her spouse. B’s spouse’s cost base of the rental property is the same as B’s original cost base plus transfer fees and capital expenditure. So B’s spouse may end up bearing the CGT on this property. But if B’s spouse uses the rental property as his or her main residence from the time of the transfer up until it is sold, the main residence exemption will protect B’s spouse from any CGT because, under section 126-5 the transfer date is the acquisition date so for the whole time of ownership it has been B’s spouses main residence. Note for the purposes of section 115-30 the acquisition date is B’s acquisition date so that the 50% discount will be available immediately to B’s spouse if B had held the property for more than 12 months.
The above will not work if the property is transferred from a company rather than a spouse. Rollover relief under Section 126-5 is still available but, under section 118-180(1), the spouse is considered to have acquired the property at the date the company or trust originally acquired it so the property will always not be considered the spouse’s main residence for the period it was owned by the company or trust.

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1) If the properties are postively geared better in partners name assuming not long term hold when partner may be in a higher tax bracket than you. Negatively geared may still be better in partners name if make good gains depends what bracket partner in when sell and whether half the gain exceeds negative gearing during period held. In otherwords you need to crunch the numbers if the property is negatively geared.
2) Assuming you hold the property for more than 12 months then half the gain would be taxed at your marginal rate depending on your total net taxable income for the year. Add Medicare levy as applicable to the following.
No tax on first $6,000
17% 6,001 to 21,600
30% 21,601 to 52,000
42% 52,001 to 62,500
47% Over 62,500
If do not hold the property for more than a year than all of the gain will be subject to the above.

3) No entity qalifies for the CGT discount if property held for under 1 year. So you are looking at the relative tax rates of the holder of the property. Individuals as above discrtionary trust as above regarding the beneficiaries (fexability a bonus), companies 30% but no 50% CGT discount available if keep for over a year and you still have to get the money out of the company one day. Super funds 15%.
Niether Trusts or companies can distribute a loss. Discretionary trusts can effectively pass the 50% CGT discount down to beneficaries if property held for more than a year.

If you send me your e-mail address I will send you a free copy of our CGT booklet and our Rental Property Booklet.

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