Interest expenses are often an investors largest tax deduction. You must realise that the onus of proof is on the taxpayer (you), not the ATO. That is, you must be able to prove to the ATO that your deductions are legitimate. If you are not able to do that unequivocally, you risk the tax deduction being denied in full (and you will have to pay interest and penalties).
Therefore, it is wise to understand some basic tax rules so that you do not inadvertently put any of your tax deductions as risk. There is a lot more detail (whole chapter) in my latest book, Rules of the Lending Game, but below is a summary of the top 10 rules that relate to investment loans.
(1) You only get one chance to set the maximum tax-deductible loan
The initial amount you borrow when you first acquire an investment will be the maximum tax-deductible loan amount.
For example, if you purchase a property for $800,000 the total cost of the acquisition will be $845,000 including stamp duty. If you have $300,000 of cash, you need to borrow $545,000. In this situation, $545,000 will be the maximum tax-deductible loan. You cannot go back to the bank and increase the loan at a later stage because the “purpose” determines it tax-deductibility (which I discuss below). A possible solution to this would have been to borrow the full cost and deposit monies in a linked offset – more about this below.
(2) Loan applicants may not have tax consequences
Who’s name the loan is in (i.e. the loan applicants) typically has no impact on the deductibility of the debt. From the perspective of the ATO, especially with spouses, the main determining factor regarding deductibility is (1) who owns the asset in question – i.e. whose name is on the title; and (2) who has been making the repayments.
For example, if the investment property is in the husband’s name but the loan is in joint names, and repayments are being made from a bank account that is solely in the husband’s name, the husband should be entitled to 100 per cent of the tax deduction (Taxation Ruling TR 93/32).
It’s preferable (and cleaner) if you can arrange for the name(s) on the loan to match the name(s) on the title, as this eliminates any doubt. However, some lenders’ policies or procedures might make this difficult, costly (in terms of time or legal costs) or impossible. It’s wise to document why the loan has been established in this way – that is, because the bank declined to set up the loan solely in the owner’s name.
(3) The owner must make loan repayments
A common mistake is that repayments in respect to a loan used to fund an investment in one spouse’s name come from a joint account i.e. in both spouse’s names.
In this situation, the ATO could argue that since both of you have been repaying the loan, the deduction should be split. However, since only one spouse owns the property, only that spouse is entitled to a deduction – and consequently now half of the interest is not tax deductible!
To avoid this risk repayments should be debited to an account that is solely in the owner/s name.
(4) A loan’s security does not matter
The property/s used to secure a loan has no bearing on its tax treatment whatsoever. For example, you could have an investment loan secured by your home and it would still be tax-deductible. The purpose for which the funds are used and who’s been making the repayments will determine the tax-deductibility.
(5) Purpose is king
Ultimately, the biggest determining factor as to whether interest is tax-deductible is the purpose for which the loan funds are used. This is what the ATO looks at in the first instance. If the item being financed is used for a purpose which has a direct relationship with earning assessable income (such as rental income and capital gains), then any interest charged in respect to the loan which finances that asset should be tax-deductible. Once this is established, the ATO then consider (1) who owns the investment; and (2) who’s been making the repayments. These factors determine who is eligible to claim a tax deduction.
Therefore, if you established a loan to purchase an investment property which earns assessable income, and one spouse owns 100 per cent of that investment property and makes the repayments, then that spouse is 100 per cent entitled to the deduction.
Sometimes people ask; “Should I borrow against my investment property to repay my home loan?” The answer is always ‘no’, because it comes back to the purpose test. The purpose of the new loan would be to repay the home loan, which is a non-deductible purpose.
(6) Don’t mix loan purposes!
There are lots of reasons not to use one loan for multiple purposes e.g. to use part of the loan to invest in property and part to invest in shares. Or worse, mix home debt and investment debt in the same loan. The predominant reason is that it makes record keeping difficult and therefore puts tax deductions at risk (because it weakens your justification for claiming a tax deduction).
Another reason is that it can become a nightmare should you want to repay only part of the loan. The tax rule is that any repayment to a loan must be apportioned across the whole loan. You cannot allocate your repayment to just one loan purpose. Therefore, you must separate loans by purpose.
(7) Redraw: be careful using it
Redraw is the ability to withdraw any extra repayments. The ATO treats any redraw as a separate loan, and once again, its tax-deductibility comes back to the purpose test. For example, say that a client has a $300,000 investment loan and receives a $20,000 bonus from work. They intend to use the bonus to take a holiday at the end of the year, and so they park the $20,000 in their investment loan in the interim to save interest. This will be considered an extra repayment. If they then redraw the $20,000 at the end of the year to fund their holiday as planned, the ATO will deem that they now have two loans – one for $280,000, which is still tax-deductible (being the balance prior to the redraw), and one for $20,000. This latter amount is no longer tax-deductible, as the loan’s purpose was to finance a holiday.
Essentially, when you repay a loan, you can deny yourself a future tax deduction, as you can’t simply redraw the loan back up to the original amount. You must be careful about when you use a redraw facility.
(8) It is much better to offset debt, not repay it
The problem with repaying an investment loan (whether through regular or ad hoc repayments) is that you change the original tax nature of the debt. That is, as discussed earlier, if you redraw the money at a later stage, it will be treated as a new loan for tax purposes. Therefore, it’s important to preserve the original tax-deductible loan balance, which also preserves your potential future tax benefits.
An offset gives you the best of both worlds – it allows you to park extra cash in it to offset the loan and reduce the amount of interest you pay, but also preserves the tax-deductible balance of that loan.
The bonus is that if you ever need to pull that extra cash out of the offset to use for a non-deductible purpose in the future, you can do so in a more tax-effective manner. This is a perfect structure particularly for first home buyers as it allows them to minimise interest whilst preserving the loan amount in case their property becomes an investment in the future.
(9) Borrowing expenses are tax deductible
All borrowing expenses are tax-deductible if they relate to investment loans. Any costs under $100 are deductible in the year that they’re incurred. Any costs over $100 are deductible equally over the term of the loan or five years, whichever is less. As mortgage terms are almost always longer than five years, borrowing costs are deductible over the first five years of the loan. If you refinance or repay your loan earlier than the five-year period, you can claim the balance of the expense which you haven’t claimed a deduction for yet.
Deductible costs can include expenses at time of purchase, such as application fees, title search fees, lender’s legal fees, valuations, mortgage insurance, mortgage stamp duty, loan repayment insurance, settlement fees, security or guarantee fees. Basically, any third-party fees that are payable up-front, whether they’re government or bank charges, can be deductible.
(10) Keep a good paper trail
It is vital to maintain a proper paper trail. You must make clear, concise notes and keep track of all loan balances and transactions related to your investments throughout the year. If you do get audited, it’s handy to be able to go back to your notes and calculations to prove and demonstrate exactly how you arrived at a particular tax deduction and/or what that amount was used for. This is particularly relevant when you’re paying deposits, refinancing, transferring funds, paying related expenses for properties and so on. What is clear to you today won’t be as clear in five to ten years’ time, so good record keeping will help a lot.
Get tax advice
There are two reasons to visit your accountant. The most obvious – and something that people generally only consider once a year – is for the preparation of your tax return.
The other thing an accountant will do is to provide taxation advice about how you should set up and fund your property investments. This is of the utmost importance and I highly recommend you be prepared to pay for it. Don’t be tempted to ‘shop around’ for an accountant based on fees alone. This is one area where you want to make sure they know their stuff.
Warning: Whilst the author, ProSolution Tax Advisory and all its directors are registered tax agents, you must not rely solely on the above information. This blog provides a summary only. Exceptions apply to all tax rules and as such, you must consider your individual circumstances. Therefore, you must obtain personalised tax advice prior to acting on any information contained in this blog.
You may also like to watch this recent presentation
The below video is a recording of a webinar hosted by Stuart Wemyss in September 2020 outlining how to successfully structure home and investment loans.