Disposal of property with subsequest reduction of loans

Question

I have 3 loans with one bank. Loan 1 = PPOR with balance 1.431 mil. Loan 2 = $408K which is the total of 3 refinanced investment property loans against 3 properties. Loan 3 = Line of Credit with limit of $492K and $370K drawn with a 70% private use component.
I have disposed of one of the properties used as security against Loan 2- it made up $215K of that loan of $408K.I must "pay back" the bank $510K of the $850K sale proceeds. I want to distribute the sale proceeds the most tax effectively.
1/ If I reduce Loan 2 by $215K, can I continue to fully claim the interest charged to the 2 remaining properties.?
2/ If I reduce Loan 3 by $295K, then does the remaining balance of $75K still retain it’s 70% private component when it comes to tax deductibility.? I am told paragraph 30 TR 1999/D3 applies here and I cannot simply pay out solely the private component of the balance owing.
Any suggestions are welcomed!
Thanks in advance
Adele

Answer

Adele,
I am assuming the amounts and properties you talk about are the amounts owning in connection with those properties not just how the loans are secured.
Yes you will have to pay $215,000 off Loan 2 or lose deductibility for that portion of the interest. If you pay the $215,000 off loan 2 the rest of the loan will be deductible against the other properties. The rest of the sale proceeds are yours to do with as you please, as far as the ATO is concerned so if the bank is making you pay some back make sure it is off the non deductible private debt. Any amount you pay off loan 3 will be apportioned between deductible and non deductible so as you say 70% of the remaining balance will still not be deductible. I am surprised that you don’t just pay it off your PPOR. If you do want to pay off loan 3 it would be best to refinance loan 3 into two loans one for 70% of the amount owing and then pay out that loan.
I have reproduced below 3 paragraphs from TR 2000/2 that explains these concepts in more detail. But hopefully my explanation above is easier to understand.
16. Where interest accrues daily under a mixed purpose sub-account, a taxpayer is entitled to a deduction in respect of that part of the interest that has accrued on the portion of the outstanding daily loan balance attributable to an income producing purpose. In calculating the portion of the outstanding daily loan balance attributable to an income producing purpose, any repayment of principal is applied proportionately against the outstanding balance of amounts applied to income producing and non-income producing purposes respectively, at the time the repayment is made. However, there are two exceptions.
First Exception – Borrowed money recouped and repaid
17. Where money borrowed and applied to a particular use (the ‘relevant use’) is recouped in whole or in part, in the sense that the amount or some part of it is recovered ( e.g., on the sale of an asset purchased with borrowed funds) that part of the outstanding balance of the mixed purpose line of credit debt which had been applied to the relevant use can no longer be regarded as continuing to be applied to that use. Where borrowed funds recouped are repaid to the mixed purpose sub-account in reduction of the outstanding balance, those funds have ceased to be outstanding funds used for any purpose. The effect of the repayment of the recouped funds to the mixed purpose sub-account is to reduce only that part of the outstanding line of credit debt applied to the previous use of those funds. The use of the balance of borrowed funds still outstanding is unaffected by the recoupment and repayment in these circumstances unless the amount of the sale proceeds paid into the mixed purpose sub-account exceeds the amount drawn down and applied to the relevant use (the ‘relevant debt portion’). This would occur, for example, where the asset is sold at a profit and part or all of the recouped borrowed funds and profit are paid into the mixed purpose sub-account. To the extent that the payment exceeds the relevant debt portion, such excess amount (i.e., the profit component) will be taken to have reduced prorata the amounts borrowed and applied to uses other than the relevant use.
Second Exception – Refinancing mixed purpose debt
18. A taxpayer may choose to refinance a debt outstanding on a mixed purpose sub-account by borrowing an equivalent amount under two separate accounts or sub-accounts. If the sums borrowed under those two separate accounts are equivalent to the respective income producing and non-income producing parts of the existing outstanding debt, we accept that interest accrued on the debt incurred in refinancing the income producing portion of the mixed purpose debt will be deductible.

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