Deducing Interest Rates During Tax Time

For most geared investors, interest is generally the largest deductible claimed against rental income, so it demands the most attention.

A ‘Negatively Geared Investment Property’ is when interest on a loan helps to produce a rental loss over a financial year.

This net rental loss is generally offset against the owner’s/landlord’s other income, reducing their payable tax, and may makes the investment property more attractive. Ensuring that interest can be claimed as a deductible is therefore critical.

Solutions that offer a faster reduction of a home loan balance while maximising deductions of interest on rental investments should be carefully scrutinised. In the case of ‘Split’ loans which in their various forms generally mean interest on the investment loan is capitalised, while all income including rent is directed towards reducing the home loan with its non-deductible interest expense.

This type of arrangement may be considered tax avoidance. Interest on the capitalised interest (interest charged on interest) may not be deductible (this depends on the ATO).

From my research here is a way if you are about to refinance or purchase a rental property on how to set up your loan arrangement so that you are likely to be in the best position to take advantage of any circumstances where the ATO concedes capitalised interest is deductible. No guarantees here but the following loan structure avoids most of the obvious traps though of course at this stage do not claim any capitalised interest without first obtaining an ATO ruling:

1)      Use all the available equity in your own home to secure a loan for the maximum amount you can. Use this loan to pay for the rental property. No doubt you will need more than that. The second loan can be secured by the investment property but this should leave available equity in the investment property to secure a line of credit should you later want to do so. This further reduces the link between the loan where the interest will be capitalised and your home. The ATO cannot argue that effectively you are not reducing the debt on your home but only shifting debt fromnon-deductible to deductible.

      2)      Do not have the home loan linked to other loans i.e. with a floating cap. It is fine to have a split facility with all your deductible debt but keep the home loan outside of this facility. 

      3)      Do not use a product that is marketed in any way for tax benefits.

Given the attitude of the Australian Taxation Office (ATO) – it is recommended that rental income be deposited into the rental investment loan account to cover the interest expense. When rent is less than interest and other expenses, using another loan, including a line of credit, is practical.

The interest on that component should be deductible. Where the line of credit is also used for private expenditure, keep detailed records to calculate the deductible portions of interest and to explain to the ATO in case of an audit.

Detailed documentation is also recommended when consolidating several small loans into one or two new loans on a re-structure or when borrowing more to finance a next investment after a positive revaluation.

I strongly suggest as always consulting your financial adviser or accountant see if negative gearing is ideal for your financial situation.