Ask Ban Tacs Question
My husband and I own a PPOR and 2 rental properties. We have various Lines of Credit against all 3 properties which were set up more than 10 years ago. None of the lines of credit are drawn down. The total value of them is $500k. The interest rates on the lines of credit are very high.
We are wanting to refinance these lines of credit so we have finance ready for investment at more reasonable interest rates. We have been advised by various mortgage brokers that banks no longer want to provide Lines of Credit. What they suggest is the following:
- Refinance the lines of credit into normal 30 year investment loans.
- These investment loans will be drawn down at settlement and the funds placed into offset accounts for each of the loans.
- The proceeds of the loan will sit unused in the offset account until they are used for investment purposes – eg as a deposit on a rental property. No interest will be charged until the funds are used.
We are able to create a number of these loans so that we do not mix the purpose. This could look like:
- Loan 1 $50k Private Purpose
- Loan 2 $250k
- Loan 3 $200K
The intention would be to use Loan 2 and Loan 3 for investment purposes eg deposits on an investment property. However, there will obviously be some delay between setting up this arrangement and further investment purchases.
Do you think that this arrangement would enable the interest on loan 2 and 3 to be deductible?
Would it make any difference if Loan 3 was not used for some time – eg 2 years?
The original intention was to use Loan 3 for investment purposes, however if we decide to use it to renovate our PPOR first, my concern is that doing this then sets the purpose of loan 3 going forward to a private purpose.
If we then increased the offset on Loan 3 back to $200k and we were no longer paying interest for a period of time and then used that $200k in the offset account to purchase another investment property, my concern is that the interest would no longer be deductible because the original use of the funds was for a private purpose.
Could you please advise whether in this scenario you consider that the interest would be deductible once the money is used for investment purposes?
Answer
The basic rule is – what the borrowed money is used to buy determines whether the interest on the loan is tax deductible. The link between the borrowing and the expenditure is called the nexus. This nexus needs to be very clear. You need to be able to show exactly how the money borrowed was used to purchase an asset that is producing income. For the interest on a loan to be tax deductible it must be a cost of earning taxable income.
The danger with offset accounts is that funds withdrawn from the loan and placed into the offset account can lose that nexus with the loan, if they sit there too long or are mixed with other funds. A principle established in Domjan’s case AAT 2014 is that once borrowed funds are mixed with private funds the nexus is lost.
Wilma Domjan withdrew money from her loan, deposited it into her cheque account and then wrote cheques to pay for work done on her rental property. In all but one case there were already private funds sitting in the cheque account. The court ruled the nexus between the borrowings and the rental property was lost. The borrowed funds were mixed with private funds so the borrowings were for private purposes, no tax deduction on that portion of the loan interest. There was one exception, when she drew money from the loan account and deposited it into her cheque account, there were no other funds in the cheque account at the time of the deposit, right through to when the cheque, for rental property repairs cleared. In this case the court decided that the borrowing was for tax deductible purposes.
Accordingly, you may get away with drawing loan funds down into an offset account to very promptly pay for a tax deductible expense if the account has nothing else in it during that time. Don’t let the money sit around while, say you look for a property, just incase the ATO views them as having become savings. Further, do not deposit anything else in that account while the borrowed funds are there and certainly don’t draw on it for private purposes, not even a little. I haven’t been able to find it but I did have an informal guidance from the ATO saying that they would be ok if the money went from the loan into an empty office account and then paid for the income producing asset but if it hung around there was no getting around the fact that the offset account is a personal savings account and that is where the borrowed money went so no nexus when the money is finally used. Considering the amount at stake and the period of the loan I would prefer you take no chances and do not draw on these loans until the money can go straight to the settlement on a new property. This may mean delaying refinancing.
If you have used a loan for private purposes then you need to repay it right down in the loan account (not the offset that is just a separate savings account) if the loan has been paid off then you redraw for deductible purposes the interest will be tax deductible.
I would like you to consider 30 year P&I loans as they normally qualify for a reduced interest rate compared with interest only loans and LOC. With interest rates so low. A 1% reduction in interest can result in reducing your interest bill by a third which is a fair bit extra towards the principle repayments. For example:
The monthly principal and interest repayments on a $300,000 loan over 30 years at 4% would be $1,432. Whereas the interest only repayments at an interest rate of 5.5% on $300,000 would be $1,375 a month. That is only an extra $13 per week and the loan is paid off in 30 years! $13 per week x 52wks x 30 years = $20,280 over 30 years in extra repayment yet the $300,000 has been paid off. That is $280,000 paid in interest savings.
Don’t think that good record keeping will help. Wilma Domjan was commended on her record keeping. The safest option is to pay tax deductible expenditure straight from the loan account and never put borrowed funds into an offset account.
