Unless you are very wealthy and are paying for your investment property in cash, chances are, like most investors, you will have to borrow to invest. When investors negotiate with lenders, the most instinctive desire is to get a good deal, which will involve comparing the features of different loans such as interest rates, fees and charges, etc. Alternatively, some investors may engage the services of mortgage brokers, who could do some of that hard work. Regardless of the approach you choose, your effort could go to waste if the financing arrangement trips over the tax rules, which may inadvertently give you a tax problem.
In this article, we look at a few of the most common tax mistakes that can be made with investment property financing, which may hopefully help you avoid some of the pitfalls.
1. Mixing purposes
In the midst of trying to secure finance to settle an investment property, it is easy to overlook the administrative details, which may have far reaching tax consequences. The most common issue I see as an accountant is mixing the purpose of a loan, which is easier to commit than one realises.
Consider the seemingly innocuous scenario where you have negotiated a line of credit with the bank to purchase an investment property. You happen to have a few personal credit cards you wish to pay off, so when you draw down the funds from the line of credit to settle the property, you draw extra monies to pay off those credit cards.
What you have effectively done is mixed the purpose of the monies drawn from the line of credit account. As only the interest expense that is attributable to the income-producing purpose of the loan is tax-deductible, you will now have to apportion the interest on the line of credit account at the end of the year to determine the tax-deductible portion of the interest.
This is a more complex process that you may realise; for instance, every repayment amount on the loan will need to be apportioned between the income-producing and private portions of the loan becausse the tax office will not accept that the repayment is, for instance, wholly related to paying down the private portion of the loan.
Due to the complexities involved, you would most likely need to ask your accountant to do the work, which will require additional time on their part and will ultimately translate to more costs for you.
Even if the other purpose of the loan is related to a different income producing activity, for example, as working capital for your business, the appointment exercise will still be necessary because you are generally required to disclose the interest you are claiming as a tax deduction against different income-producing and/or business activities separately in your tax return.
The key to avoiding this problem is to ensure that each loan drawn down is specifically related to a single purpose.
Using the above scenario, it would be advisable for you to ask the bank to create separate line of credit accounts instead of one. You may then use one of those accounts exclusively for the purchase of your investment property and simply claim the entire interest expense incurred on that account at the end of the year.
2. Changing purposes
This is also a common occurence that is often difficult to rectify without incurring substantial costs.
You borrow from the bank to buy a home. As you are keen to pay down the mortgage, you put every spare dollar you have as repayment on your home loan, knowing that you could redraw funds from this loan if you ever need them. A few years down the track, you decide to upgrade your home but wish to keep the existing home as an investment property, so you redraw funds from the existing home loan to buy the new home.
You determine that by redrawing the funds, the existing loan principal will be maximised and as this loan is connected with your existing home which will become an investment property, you may claim the interest on this loan as a tax deduction once the property becomes available for rent. Meanwhile, you are maximising the equity you are putting into your new home and therefore minimising the non-deductible interest.
In theory, the idea that the interest incurred on a loan that is connected with an income-producing purpose is taxdeductible is correct. On the surface, under the above scenario, you will end up with the existing loan that is connected with an investment property and a new loan that is connected to your new home.
The problem is that the tax rules are very literal when it comes to assessing the purpose of a loan and these rules adopt a strict tracing approach to determine how the drawn funds are applied. In the above scenario, when you redraw funds from the existing loan to buy your new home, the purpose of the redrawn funds is now attributable to the acquisition of your new home, which is not an income producing asset. Accordingly, the interest expense on the existing loan that is attributable to the redrawn funds will no longer be tax-deductible.
As an ancillary problem, the existing loan, due to the redraw, is now attributable to mixed purposes, which will create interest apportionment issues as detailed above.
One way to avoid this type of problem is to have the foresight of planning upfront so that your arrangement will give you the maximum flexibility in future.
For instance, if you originally set up the home loan such that all your additional home loan repayments are put into an offset account that is attached to the home loan, you will get the best of both worlds – every dollar you deposit into the offset account will reduce the interest on the home loan as if the amount is deposited directly into the home loan. If you redraw monies out of the offset account, the purpose of the funds for which the original home loan was drawn will not be disturbed.
Therefore, by withdrawing monies from the offset account to buy the new home, you are effectively maximising the original loan that is connected with your original property, the interest on which will become tax-deductible when the property becomes available for rent.
On the other hand, if you did not set up the offset account when the original property was purchased, it will not be easy to change the unfavourable outcome described above without, say, transferring the property, which will obviously give rise to stamp duty and potentially other costs of transfer.
3. Entering into tax schemes
Sometimes investors find themselves drawn in by newest and latest tax schemes on the market, which promises to save tax and fast track their investment goals. The problem with tax schemes is that they may not have been tested by the Tax Office or the courts. Given that you are ultimately responsible for your own tax affairs (yes, even if your tax return is prepared by someone else), you ultimately bear the tax risks of entering into the scheme if the taxman subsequently challenges the position you have adopted.
One of the financing-related tax schemes is the use of a ‘split loan’ or ‘linked loan’ arrangement.
In a typical split-loan arrangement, the lender opens two accounts for you – one is a home loan while the other is an investment property loan. As part of the facility, the lender calculates the loan repayments (and interest) on the aggregated loan balances of both accounts but each loan repayment is applied exclusively to the home loan. Meanwhile, no repayment is required on the investment loan and the interest expense incurred on the investment loan is capitalised and added to the loan principal.
This arrangement has the effect of compounding the taxdeductible interest on the investment loan and, at the same time, accelerating the repayment of the home loan.
The arrangement went before the High Court in the Hart case and the decision put an end to split loan arrangements as a tax effective strategy.
Creative scheme promoters have since come up with somewhat similar arrangements that purportedly can be legally distinguished from the Hart case, which prompted the Commissioner of Taxation to adopt a ‘substance over form’ approach to knock these arrangements on their heads in Taxation Determination TD 2012/1.
Essentially, these arrangements enable allegedly taxdeductible interest to be capitalised on the interest incurred on an income-producing loan while any loan repayments made are directed exclusively to reduce the private loan.
These types of financing schemes may be attacked by the Commissioner in a variety of ways. For instance, he may simply argue that the scheme was entered into for an additional purpose (for example, the purpose of reducing one’s tax liability), which means that the interest incurred that is attributable to this additional purpose will not be tax deductible. Alternatively, he may simply invoke the general anti-avoidance provisions in Part IVA to deny the relevant tax deduction on the basis that the scheme was entered into with the sole or dominant purpose of obtaining a tax benefit.
If the Commissioner is successful, you are not only at risk of having to pay back the primary tax avoided, but it is likely that an administrative penalty will be imposed, as well as interest on the tax owing. The financial penalty could be crippling.
The most obvious ‘solution’ is to take tax schemes with a grain of salt. There will always be seemingly attractive tax products out there, the promotion of which seems to get even more prolific near the end of each financial year. It is wise to stay away from products that have not been tested. At the very least, ask the promoter for a ‘product ruling’, which provides evidence that the promoter has obtained a sign-off from the Tax Office regarding the tax implications of the arrangement. Even so, having a product ruling does not mean that the scheme is bullet-proof as the ruling will only provide protection if the promoter has not changed any material aspect of the scheme, compared to that described in the ruling application.
What if you are already in such a scheme? Given the heightened sensitivity of the Commissioner in his dislike of these schemes, I would suggest that you consider restructuring your finances to get out of the scheme altogether. If this is too costly or cannot be done easily, at least negotiate with the lender such that no additional interest is being capitalised on the interest incurred on the incomeproducing loan, for example, pay the interest in cash rather than let it roll into the loan principal. Further, you should consider amending your tax returns from previous years to remove the interest deductions claimed that were attributable to the capitialised interest. The principle here is to put yourself in the same position as you would be without having entered into the scheme, which may minimise the damage if you find yourself coming under attack.
Eddie Chung is partner, Tax & Advisory, Private clients with BDO (QLD) Pty Ltd
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and reponsibility to any person in respect of anything and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.
This feature is from the September issue of Your Investment Property Magazine. Download the issue to read more.