Capitalising interest refers to the practice of adding the accrued or accumulated interest to your loan principal instead of them being paid. In capitalising interest, the loan amount continuously increases, and so does the total cost of the loan. Basically, you are paying interest on your interest. As a result, you pay more and more interest over time. Capitalising interest is normally done through a line of credit loan (LOC).
The Australian Taxation Office has flagged it will crack down on property investors claiming deductions for interest expenses if they are using some or all of the rental income from an investment property to pay off their own home loan while adding the interest from the investment loan to the principal of the investment loan and claiming all the interest of the investment loan as a deduction.
In a determination in March 2012, the ATO said it would reject such arrangements.
This mean if your loan arrangement incorporates features that would effectively give rise to the capitalisation of interest on an investment loan while the loan repayments are used to pay down the principal of a private loan you should be warned that this is now NOT a valid arrangement to maximize your tax benefit from investment property.
The ATO’s determination will apply retrospectively and could affect a landlord’s past income and deductions, potentially costing them thousands of dollars.
The advice is that property investors should be conservative and avoid claiming deductions for any compounding interest on their investment loan.
However, according to BAN TACS Accountants Pty Ltd, if the loans you use are simply accounts used by people that would not necessarily be looking for a tax benefit, you may be ok with your current loan arrangement. If you can provide valid reasons for not making the interest payment on the rental property which is considered by the ATO to be more dominant than the tax benefit, it should be relatively safe to capitalise interest of your investment loan.
Some examples given by BAN TACS Accountants Pty Ltd include:
1) Wanting to save for a holiday or safety net for unforeseen circumstances. Choosing to do this through the offset account attached to your home loan is practical as your only other source of funds in an emergency is the LOC used to pay rental property expenses. If this was accessed for private purposes it would create the record keeping nightmare of interest apportionment on a mixed purpose loan.
2) Your home loan is over 10 years so the repayments are high, add to this a detailed budget of your living expenses and you just can’t afford the interest repayments on the rental property but fortunately, you have enough equity to secure a LOC for these borrowings.
3) You have organised the LOC so that you have all the rental property expenses recorded separately and on one statement and so that you can be sure that payments are met when due because you have so much available credit. All your income is directed to the offset account for you home loan. The question you have for the ATO is what happens when due to the order that expenses are drawn from the LOC or because the property is negative cash flow or because you are not that organised and irregularly transfer money into the LOC and then only what you feel you can afford considering possible private expenses. As a result of any of these interest will capitalise on the LOC is this also caught by Part IVA (the general anti-avoidance rule for income tax). Is the dominant purpose of your lack of attention to your accounts on a daily basis, to obtain a tax benefit?
4) It is your intention to start a family as soon as it is financially viable but it is a personal choice that during the first few years of your children’s life that you will live off one wage. To be able to manage on such a reduced income you will need to be far enough ahead on you home loan to not be required to make repayments during that period. The question for the ATO is whether letting interest capitalise on you rental property while saving to have a family is a scheme with the dominant purpose of a tax benefit.
5) You had thought you could meet your financial commitments but due to a change or circumstances such as pregnancy, demotion, unemployment, sickness etc you are finding it difficult to pay your bills and are anxious about future doctor’s bills unemployment etc. You wish to concentrate all your income towards you offset account to ensure you can meet your home loan repayments and emergencies. Fortunately, you have plenty of equity so can use a LOC to support the rental property. Is the ATO going to use Part IVA to force you to borrow for personal expenses rather than rental property expenses?
6) The interest rate on your private debt is higher than that on the LOC. This maybe because your private debt is a credit card or car loan. It may even be the case with your home loan. This scenario may even be the one opportunity where the way the loans are organised can affect the success of your arrangement. In this case you argue that your dominant purpose is simply to reduce your interest expense by paying the highest interest rate loan off as soon as possible.
7) If you have sufficient equity in assets other than your home to finance the growing LOC debt then the concept of paying off your home sooner has much more punch. You dominant purpose could be to make sure that only your rental properties are exposed to risk of mortgage repossession.
You will always be in a better position if you can show that it is not you intention to access the increased equity in your home to extend the line of credit (LOC). It is also ideal that the LOC is secured against your rental property which may have available equity if the original borrowings were partly secured by your own home. The LOC can also be justified as a record keeping tool because you pay all and only rental property expenses from it so you only need to refer to that account when preparing to lodge your tax return.
The final advice is that rather than falling victim of such drastic action, you should make application to the ATO for a “Private Ruling” on whether they would apply Part IVA to your particular circumstances before you claim capitalised interest.