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Hi,
How are you? I am a small business owner of an accounting firm (no employees). I have already asked the below question to another accounting organisation but the answer was brief. I love your answers, and want confidence in our work so would appreciate if you could help. The scenario and question:
I have a client of 2 brothers who had purchase an investment property via a loan in joint ownership (Bare Trust arrangement). They then built another investment property in the backyard land and drew down on the original loan to do so. They then, knocked down the original home in the front and built 2 townhouses in the front via drawing down on the original loan. They since, sold one of the front townhouses, did not pay off that portion of the loan that referred to that property (that portion of the loan has not been deducted from this point – the loan is 67% deductible from this point). They rented the 1 townhouse and the property in the back for a number of years (over 5 years).
Fast forward to now, they partitioned the 2 properties i.e back property transfered to one brother and the other one to the other. Valuations were conducted on the 2 properties. Lawyer confirmed no capital gains. The original loan which includes the original drawdown for the original whole property, then the drawdowns for the build of the property in back built in backyard, and then the build for the 2 front townhouses (of which one was sold soon after it was built – but not paid back on loan), was then split between both brothers according to the valuations conducted on the 2 homes left and partitioned.
My question – the 2 brothers now have separate loans each which comprise of the original loan they had together but split as mentioned – how is the loan deducted going forward for each brother? Do each claim 67% of the interest on each of their new loans? The original loan was not split equally to each brother as the market values at time of partitioning are not equal for the 2 properties split. The answer I received from the accounting body I asked and paid for advice: <<With regard to your query, as the original property was in joint ownership (presumably 50:50) and everything since then has also been jointly done (up to the date of partitioning), the split ofthe loan will presumably follow the original property and it will be dividend equally between them. This should have been regularised by the the redemption of the original loan and thecommencement of new loans with the bank (for which there should be new loan agreements which should be available to you on request)>&g t;
I appreciate your assistance here. I just need to be confident here, thank you
Answer
I attach our apportionment spreadsheet that maybe helpful. The key ATO ruling for mixed purpose loans is TR 2000/2 https://www.ato.gov.au/law/view/pdf/pbr/tr2000-002.pdf
The key rules are what the money is used to buy determines whether the interest is tax deductible, paragraph 12. If there are various uses of the money then the interest and all repayments (other than the sale proceeds of something bought with the money) are to be apportioned on the ratio of these various uses, paragraph 13 & 21. That is what the spreadsheet allows you to do in the situation where the draw downs are over time so the ratio changes as per paragraph 20. If the ratio just went from 100% to 67% then you won’t need the spreadsheet but if it does get a bit messy the spreadsheet will make an excellent working paper. It may also be helpful in working out whether the 67% is higher than that.
Other important points from TR 2000/2:
Paragraph 15 – a reasonable method of apportionment is acceptable
Paragraph 14, 23 & 24 – If you can trace the sale proceeds of the asset originally borrowed for to another income producing asset the interest can be deductible against that
Paragraph 18 – To untangle a split purpose loan you can organise 2 new loans for the individual split balances and pay out the old loan at the same time and then each individual loan can be 100% for its purpose. This is a method they can eventually use to concentrate on paying down the 33%.
Paragraph 17 – If you sell an asset that was borrowed for when those funds go into the loan they do not have to be apportioned, they pay off the original borrowings for that asset unless it is more than the balance borrowed for that asset then the remainder is apportioned. But it sounds like nothing went into the loan.
Is there any chance that the sale proceeds re the 33% could be traced to another income producing purpose?
So now applying this to your circumstances. What were the borrowed funds used to buy? Tough question. It would seem the settlement arrangement was you take this property and this loan ……
I do not accept that just because they own the property 50:50 that half the loan is tax deductible to each of them. That does not apply the principle of what was the money used to buy.
You say there was a bare trust arrangement in place – partitioning. No CGT because no actual sale just a vesting of the trust. Bare trust basically means it has always been as it is so I don’t think that gives us any reason to change anything ie not be able to now say 100% of the new loans are tax deductible.
I don’t think there is any room for fancy foot work here. I think you have just got to follow through with the rules of TR 2000/2 and continue to only claim 67% of the interest on whatever portion of the original loan they take. To try and say that it is now 100% deductible because it was part of the settlement arrangement on partitioning contradicts the bare trust situation of nothing has changed as one brother always held that portion for the other and vice versa. I think you need to continue to only claim 67% of the interest unless you get a private ruling. In that ruling you could try to argue that it was part of the settlement that they took on that particular loan in order to receive that particular property so was a cost of acquiring the asset. You might get lucky but the argument that they acquired the asset at this time defeats the bare trust arrangement. Have a look at the settlement contract and the bare trust arrangement and see if there is something that will help.
I am not sure why they say 50:50 when the refinancing has been done. That will be a mess. I consider the valuation ratio for the loans to be a “reasonable” method of apportionment. The valuation ratio is the easiest to calculate now the refinancing has happened and the easiest to justify as reasonable. I wonder if the firm you asked understood the question or if I have misunderstood the question.
