Borrowing to afford P&I repayments

Question

My question centres around maintaining deductability on an investment loan, but I have provided a lot of background information for you first.

Current:

– I have a Rocket Repay Home Loan with Offset (Westpac) secured against my PPOR.
– I am still within the 5 year interest only period of the 30 year loan
– Total loan amount $680,000
– I have drawn down $430,000 to purchase 2 x investment properties
– All very clean. I have never mixed any private funds. The purpose of the funds have always been for investment
– I am currently deducting the interest payments on the $430k
– I still have $250,000 in available funds

Future:

– Given the recent changes to serviceability this will likely switch over to P & I when the interest only period expires in a couple of years.
– Of course, P & I will be on the total amount of $680k over the final 25 years
– This will cause a cash flow strain for me
– Obviously, I can make a variation to the loan to reduce it down to $430k, however, this would still have an impact on cashflow.

Alternative (seeking clarification):

– Could I draw down the remaining $250k available funds and park it in offset
– This would effectively allow me to essentially use the bank’s funds to repay the loan for a few years without impacting my own cashflow. Ie the repayments would come from the offset account
– This would buy me enough time before selling another asset to fund this

My assessment:

– It seems clear to me on first glance that the use of the $250k in offset does not impact deductibility of the interest because the balance has not changed
– I think I am fine with the principal component of the repayment as this reduces the loan in kind
– However, it is the deductibility of the interest component of the repayment that concerns me. If I understand correctly, I would be capitalising the interest by the time of the 2nd repayment.

Question:
– Is this a creative but totally above board approach that would aid cash flow and still maintain deductibility of the interest component of the repayments?

– If not, could I take the same approach but immediately pay the interest component of the repayment back into the offset from a personal account each month so that there is no capitalisation?

Many thanks for your assistance…

Answer

I wouldn’t be waiting for the IO period to expire as you will probably find that changing to P&I will drop your interest rate by 1%. Further this 1% (probably 20% of what you are currently paying) will go a long way towards principle repayments.

You are absolutely correct that capitalising the interest is a bad look. The ATO eventually won in Hart’s case because they argued Part IVA dominant purpose of a tax benefit. Now before they could argue this they had to admit that the interest of borrowing to pay interest is tax deductible for there to be a tax benefit under Part IVA. Of course it is, just like in a business overdraft. The only reason the ATO got through on this was they pointed to a bank pamphlet that advised customers to capitalise the interest on their investment loan and pay more off their own home loan for tax benefits. It was the use of those words, tax benefit that was at the heart of why the ATO won the case.
So the question all revolves around what your dominant purpose is. Certainly, if you can’t afford to make the repayments then the dominant purpose of borrowing the interest is to meet your obligations not for a tax benefit.
It seems to me your dominant purpose is to be able to afford a P&I loan so that you can qualify for the 1% lower interest rate offered these days. Now my first question would be, considering the lower interest rate for P&I are the repayments that much more anyway? Also give some thought to whether you could afford them ie are you making more than the necessary repayments off your non deductible debt or could you make the term of this new loan for deductible debt longer so you could afford the repayments?

Your idea of paying the interest on the loan into the offset account is a very safe approach.

As for putting the borrowed funds into the offset account. I would prefer you to ask for a split facility so you can have an undrawn loan sitting there where repayments don’t need to start until you draw on that but I am not sure whether that is available to you. This would make the repayments on the now smaller loan much more affordable and still give you a safety net.

If you go with the offset idea be very very careful. Do not use that offset account for anything else, in fact if you put the interest in put it straight to the loan rather than the offset and just let the principle portion come out of the offset. I just don’t want you to be caught like Wilma Domjan AAT 2004 who mixed borrowed monies with personal money just to pay a bill and lost the nexus.

Now in direct answer to your question:
Paying the interest straight into the loan account from accounts other than the offset account, being careful that the only transaction through the offset account is the repayment of principle, is a safe option.

To pay any interest out of the offset account could be considered capitalising interest so you need to make sure you can prove your dominant purpose is not a tax benefit. TD 2008/27 makes it clear that the interest on borrowings to pay interest on borrowings takes the same nature as the original interest ie is tax deductible. The catch is the ATO want to effectively make capitalised interest not tax deductible by threatening any arrangement with Part IVA. To apply Part IVA they need to argue that your dominant purpose in the arrangement is to gain a tax benefit of the extra deduction. Your counter is that is the only way you could afford P&I repayments and P&I was a no brainer because it reduced your interest rate and therefore reduced you tax deduction. The key is the only way you can afford….. But if you are making extra payments off your non deductible debt that won’t fly.

If you would like to see more of the ATO’s arguments in this regard, though I don’t think they would get away with them all in a court of law, refer TD 2012/1

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