Borrowing to Pay Interest

You know I am not a fan of using a LOC unless operating and using it for a cash flow business.

Other than not using a LOC, I have no issue with this. This is good loan management if the loan you are using is at the same interest rate as the other loans.

This is different to what you have previously outlined. Normally you suggest letting the interest capitalise which is illegal.

In this case, you are paying the interest each month on the loan you obtained to pay interest on your investment loan. If the interest rates are the same, which is usually not the case using a more expensive LOC, what is the point?

Why not just pay the interest on the investment loan each month instead of the second loan which will cost you more in fees and charges using a LOC?

Robert Bou-Hamdan
Mortgage Adviser

http://www.mortgagepackaging.com.au

Investor Links

Whether you have a home with equity or not, there is nothing untoward about financing an income producing activity such as property investing and claiming the interest on it as a tax deduction.

there is also nothing wrong with using income to pay off a home loan

What I think you do need to be careful of is artificially creating or increasing tax deductions and this largely depends on the exact circumstances and the way the transactions are effected.

Obviously on a forum like this I can take no responsibility whatsoever for you acting or not acting on these comments and would suggest that on the face of it what you are suggesting is ok but must be done absolutely correctly to be effective- and therefore I would also strongly suggest you obtain advice from a fully qualified professional who will give that advice in light of your specific circumstances.

While we are on tax- now may be a good time to consider strategies such as prepaying interest- it’s much too late to plan AFTER 30th June
Cheers

Terry..why not contact Julia from bantacs through a PM or e-mail and see what she says?

“Money is a currency, like electricity and it requires momentum to make it Effective”
Count The Currency With This Online Positive Cashflow Calculator

Hi, Don’t normally post here now because of the Green words but battleships contacted me. The following is an article I wrote when Hart’s case was decided. It is a bit wordy but worth the read.

From Booklet: Rental Properties, Claimable Loans, Real Estate Agents
Hart’s Case Decided for the ATO – Linked Split Loans
NewsFlash Issue: 82
By: Julia Hartman B.Bus CPA – Tax Accountant
Last Updated: 2004, June 15th

On Friday 27th May, 2004 the High Court handed down its decision on Linked Split Loans in favour of the ATO.
I do not find it too surprising that they found that these types of loans were a scheme with the dominant purpose of a tax benefit therefore caught by Part IVA. This case was a clay pigeon for the ATO and yet it still needed to go all the way to the High Court. It was a clay pigeon because the banks marketed these arrangements on the basis of the tax savings. Therefore it was difficult for the taxpayer to argue a different motive.
It is important to remember this case does not change the deductible nature of interest or for that matter interest on interest. Gleeson & McHugh specifically stated that the question of the deductibility of interest upon interest does not need to be addressed because the issue was already decided on the basis that there was a scheme to gain a tax benefit.
The moral of the story is not to get involved with mass marketed tax schemes unless they have an ATO ruling. This is because the ATO has no trouble proving your primary motive was a tax benefit as there is always an abundance of marketing propaganda to prove this.
On the other hand don’t lose sight of the fact that you are not obliged to pay more tax than necessary. In IT 2330 the ATO states:
“Notwithstanding that an arrangement may not be capable of explanation by reference to
ordinary business or family dealing and even though it may be entered into to avoid tax, it will
not attract the operation of section 260 (now Part IVA) if its purpose is to take advantage of a
specific or particular provision in the Income Tax Assessment Act and complies in every respect with the requirements of the specific or particular provision, i.e., the choice principle.”
This approach is supported in Harts case where the judges stated;
“If such a taxpayer took out two separate loans, and the terms of the loan for the investment property were different from the terms of the loan for the residential property in that they provided for a higher ratio of debt to equity, and for payments of interest only, rather than interest and principal, during a lengthy term, then ordinarily that would give rise to no adverse conclusion under [Part IVA]. It may mean no more than that, in considering the terms of the borrowing for investment purposes, the taxpayer took into account the deductibility of the interest in negotiating the terms of the loan. How could a borrower, acting rationally, fail to take it into account?”
Unfortunately the judges concluded that such a loan was not normally available so it was not reasonable to argue it was a normal arrangement apart from the tax benefit. Ultimately it was the linking of the loans that sunk them. This should not discourage investors seeking similar loans that stand on their own merits rather than being linked to a non deductible loan.
Fine tuning this theory in relation Part IVA we need to recognise that this test has two elements. Firstly there has to be a scheme and secondly it needs to have a dominant purpose of a tax benefit. In Hart’s case it was recognised that a scheme as per 177A(1)(b) can basically include any …. course of conduct. So there is no point in poking around here for a gap other than to say the legislators could not have intended this section to be so wide or it would catch everything.
So now let’s look at the dominant purpose of a tax benefit test. Which must also be present for Part IVA to apply. No this does not mean that if you walk into a newsagency to buy an invoice book your dominant purpose was to gain a tax deduction for the book and as it was a “course of conduct’ that is it no tax deduction because this is a tax scheme. We have to be more realistic than that. Nevertheless the High Court found that Hely J was correct in stating:
“A particular course of action may be both tax driven, and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine in favour of the taxpayer whether, within the meaning of Pt IVA, a person entered into or carried out a ‘scheme’ for the dominant purpose of enabling a taxpayer to obtain a tax benefit”.
So finding another reason to justify the arrangement is not enough. It is all about the dominant purpose.
The simpler the arrangement the better, the more artificial it becomes the more it meets the definition of a scheme.
The court having disallowed the capitalised interest because it was part of a tax scheme did not have to rule on whether capitalised interest itself was tax deductible. I feel that the capitalised interest would normally be deductible providing it has not been created as part of a scheme with a dominant purpose to save tax.
Say for example you have a line of credit on your rental property and a separate loan on your home. Your tenant may pay you a couple of months rent in advance which you pay off your home loan as everything is up to date and cash flow looks good at the time. Over the next two months you have quiet a few personal expenses that take up all of your wages. Then the rates and some repairs are due on the rental property. You need to draw the funds to cover the rates and repairs from the line of credit on the rental property and due to lack of funds the interest that month has to be capitalised. Luckily you just manage to make the P&I payment required on your home loan. This scenario is not a scheme. Events just happened that way and it is not for the ATO to tell you how to manage your affairs. Linking the two loans or a systematic approach to the increase in the loan on the rental property may point towards a scheme. Just watch out for spare funds to make extra repayments on your home and don’t prop up the rental property with your spare cash if you can use the equity in your rental property instead.
This principle can also work with a business instead of a rental property.

Disclaimer: Please note this information is general in nature and constantly changing so please don’t act on it without consulting your Accountant.

Julia Hartman
[email protected]
http://www.bantacs.com.au

30 years in the ATO and cannot give a definitive answer. I have no years in the ATO and I am telling you it is illegal. I am not even an Accountant.

I think Julia was saying that if it was set up solely to increase deductions, then it is a scheme. Your scenario is set up solely to increase deductions so it is a scheme. Being a scheme makes it illegal. You would not set up another loan to pay your interest in the normal course of business.

I don’t know how much more information is needed to convince you. I don’t care how many lenders are used, I still say it is illegal.

As for Hart’s case and the loans being with one lender, this was because the loans could not stand alone. The very low interest non-deductible loan HAD TO BE TAKEN WITH the overly higher interest deductible loan. This clearly had the sole purpose of increasing deductions. To me, your scenario is the same thing.

Robert Bou-Hamdan
Mortgage Adviser

http://www.mortgagepackaging.com.au

Investor Links

hi Terry – what do you think the primary motivation would be to do this – i’m sort of thinking it could be used to minimise cashflow whilst maintaining (or slightly worsening) debt – but a method which could significantly support additional borrowings in the short/medium?? term.

To my knowledge i haven’t seen anyone do this, but it is certainly a very interesting concept.

i would think that someone doing this wouldn’t care two hoots on the tax deductiblity situation as such, but relish in the retained cashflow.

any thoughts along this line?

cheers

brahms
Purveyor of Fine Finances
aka Mortgage Broker Brisbane

Hehehehehe…

I am sure the ATO will accept this reason for a viable excuse for deducting capitalising interest at an audit.

Robert Bou-Hamdan
Mortgage Adviser

http://www.mortgagepackaging.com.au

Investor Links

So….

as long as the interest on the directly connected mortgage was claimed – then there is no issue?

(I’m also not an accountant)

the fact that other expences are capitalising should be of no interest to the tax gestapo so long as one is not claiming them…so far so good??

in essence i think it’s a cashflow advantage – probably suitable for high equity / low capacity borrowers as Rob said earlier.

also of cashflow benefit for high equity / high income or at least high sporadic income perhaps?

or, if buying for quick capital gain in a rising market / quick refurbishment then on sale – or even trading other commodities perhaps?

outside of capitalising debt – which could be exceeded by profit from the activities – any other downsides or threats to doing something like this?

any thoughts?

cheers

brahms
Purveyor of Fine Finances
aka Mortgage Broker Brisbane