Duplex to Rent Changes to Living on One Side

Question

– IP purchased 2017 with single home and approved plans for 2 town houses. A loan of $1,250,000 was drawn for this purchase, property was rented out until it was demolished/construction began in Feb 2019. – Loan interest deductions have been claimed in full (up till last Tax return 2018/2019) as the 2 new town houses were intended to be Investment properties. – My family and financial situation has changed recently due to COVID19 and we have decided to move into one of the townhouses and rent out the other – approx April 2020 – We did not borrow additional money subsequent to the original loan for building or other costs. – Subdivision is currently in progress but not complete. – Construction finished in June 2020 -We would like to separate the investment loan portion & claim interest deduction; and the other portion which is now our PPOR where we can’t claim interest deductions.

Questions:

1. Is it as simple as apportioning the original $1,250,000 loan by the ratio of land per proposed subdivision given that the original loan paid for the land and demolished house only? The land is a standard rectangular block split down the middle.

2. Is it sufficient to split the loans or does it require a full refinance? My bank advised that a split results in two new loans but want to be sure.

3. Can interest deduction be claimed during the construction period? I have read/heard mixed advice on this and changes to rules that occurred on 1/7/2019


Answer

From 1st July 2019 interest is not deductible during the construction phase. It has to be available for rent. Don’t worry about the change of mind after claiming interest in your 2019 tax return. The old ATO rental property guides quiet accepted that and just said that you just had to stop claiming interest from the time you changed your mind. The only catch here is you will not be able to use section 118-150 ITAA 1997 (the 4 year rule) to cover your home with your main residence exemption from the time you purchased or during the time you claimed interest during construction. This means you will need to keep CGT records the whole time you own the property as your main residence exemption will apply pro rata to the gain based on number of days covered by your main residence exemption and days not covered. As they are two separate dwelling they will each have their own CGT cost base.

The unclaimed interest on both sides will increase the cost base of each property. In relation to your side as the holding costs are not tax deductible these can also be included in your cost base, reference Section 110-25(4) ITAA 1997. Examples of this would be rates, insurance, cleaning materials, lawnmower fuel, light globes…….. for the whole time you live there!

The ATO will accept apportionment of the original loan on a fair basis. I would say based on square metre of land unless one particular angle has extraordinary views. So you have a mixed purpose loan. Let’s say half tax deductible and half not tax deductible. You can’t pay one side down without repaying the other while ever they are in the one loan account. So yes you will need to re finance. TR 2000/2 https://www.ato.gov.au/law/view/view.htm?docid=TXR/TR20002/NAT/ATO/00001 at paragraph 18 says this can be done. By setting up two new loans to pay down the old one at the same time. Do not let the bank talk you into just getting one new loan and splitting the balance between old and new. This will not work, you need to strictly abide by paragraph 18 which says:

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.

All the above is pretty straight forward so no need for an ATO ruling. TR 2000/2 makes it pretty clear how the loans work. Is there anything left to pay for out of your own funds? I have assumed that the building and subdivision costs are all being paid out of your own cash reserves. What I am thinking is split that loan asap. Then pay with your cash half (or whatever the percentage is) the rest of the costs and borrow the other half for the rental property costs. This will give you more of your own cash left to pay down your side of the loan. But don’t do this until after the refinance.

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