New Loans for Income-Generating Purposes

Interest paid is always deductible on a new loan, even if it exceeds the income generated by the rental property. This can include new loans taken to purchase a rental property in the first place, but it also includes any loans taken in order to maintain it, so long as the property is available and capable of generating income. Legitimate reasons for taking new loans out for an existing property might include:

• Acquiring land required for building or expanding rental property
• Renovations required for meeting building or planning codes
• Renovations required to maintain or increase rental desirability
• Purchase/replacement of depreciating assets (carpet, furniture, etc.)

 

Consider an example where Suzanne takes a new loan for $200 thousand dollars, intending to buy a building unit for commercial rental purposes. Through the rental, she expects to derive income (indirectly) from the loan. Perhaps she is able to negotiate for a lower cost on the unit—only $150 thousand dollars. She immediately puts the unit on the market, ready to generate rental income for herself. She rewards her negotiation savvy with a smashing new car, using the remaining $50 thousand from the loan.

 

As the deductible loan interest-rule applies only on new loans taken for the purpose of purchasing or maintaining income-generating property, Suzanne can only deduct the interest on $150 thousand of the loan (the portion which was applied toward purchasing the rental).

 

Redrawing from an Existing Loan

It may be possible that a borrower can redraw previous repayments of the principal of an existing loan. This situation is distinct from the “new rental property loan” scenario, because the existing loan might have been originally acquired for non-income generating, private purposes. Alternatively, the original loan might have been for an income-generating purpose and the redrawn amount for a personal purpose. The key issue here is when a loan is redrawn and creates mixed purpose use. The principle of deductible interest works the same here as on a new loan; however, the interest on this existing loan must be carefully examined to determine how much of it applies to the loan for an income-generating purpose (the rental property) and how much applies to the original, personal purpose of the loan.

 

Consider Suzanne again. Five years after she has been renting that commercial unit, the income generated from it has paid her original loan down to $40 thousand. Because she is an excellent client, the bank holding her loan offers her a chance to redraw on that loan, and Suzanne decides to upgrade her car. She draws an additional $50 thousand, bringing the total loan balance to $90 thousand.

 

Remember that the deductible loan-interest rule applies only on money redrawn for the purpose of purchasing or maintaining income-generating property. Therefore, Suzanne can only deduct the interest on $40 thousand of her current loan (the portion which was used for purchasing the rental property).

Determining Interest Deductions for Mixed Use Loans

In cases of redrawn loans, the original purpose of the loan does not determine the overall deductibility of loan interest, and mixed purpose loans must be examined to determine what part of the interest is deductible and which is non-deductible.

 

As you can well imagine, it can be quite complicated to determine interest on such mixed purpose loans, and so the ATO usually accepts monthly calculations. These calculations are based on the average outstanding principal which has been used for income-generating purposes. To determine the amount of deductible interest in any given month, calculate the Deductible Interest Percentage, and multiply it by the dollar amount of interest accrued in that month.

 

Deductible Interest Percentage calculation will require:

• Loan balance at the BEGINNING of the month— the remaining loan principal, not including interest
• Loan balance at the END of the month— the remaining loan principal, not including interest
• Loan balance at the BEGINNING of the month— only the remaining principal of the loan which is actively used for income-generating purposes
• Loan balance at the END of the month— only the remaining principal of the loan which is actively used for income-generating purposes

To calculate monthly Deductible Interest Percentage

1. Add these in pairs (add opening and closing principal together, and add opening and closing principal of income-generating amount).
2. Then divide that second number by the first; that is, divide the remaining principal of the income-generating purpose by the total remaining principal.
3. Lastly, multiply this by one hundred.

Remember to multiply this percentage by the dollar amount of interest in that month in order to determine the deductible amount of interest on that loan.

Split or Linked Loans

Informally, split and linked loans are multi-purpose loans with more formal structure than a loan which is simply redrawn for mixed uses. One distinct advantage of these forms of loans is how their structure helps to avoid potential complications or errors which may arise from mixed-purpose loans.

A split loan is a single loan with distinct sub-groups. To quote the relevant legislation, “A split loan is a credit facility taken out with a financial institution under which there is one loan with sub-accounts being maintained in respect of that loan.”

A linked loan, on the other hand, is when multiple loans are made to the same party from the same lender, but these loans are each maintained through different accounts. It is defined in legislation as “a credit facility taken out with a financial institution under which there are two or more loans with an account being maintained in respect of each loan.”

Split or linked loans also demonstrate that there is no improper inter‑mingling of deductible and non-deductible interests, since this is impossible within the structure of these loans. ATO tax laws include a provision which prohibits such practices. Without such prohibition, it would be possible re-characterise non-deductible personal-loan interest as deductible income‑generating-loan interest.

Going back to Suzanne’s example, it would be possible for her to claim that she had paid down the interest on the personal loan, which she used to buy her second car, while continuing to claim all remaining interest as the deductible interest from her rental purchase loan. But this would be impossible if, instead of redrawing on the same loan, Suzanne had taken out split or linked loans.

 

However, split and linked loans bring complications of their own, and so it is most advisable to consult with a financial advisor who can make the soundest recommendation for any particular case of mixed-purpose loans.

Loan Account Offset

While split and linked loans refer to multiple (or complex) loans from the same lender, loan account offset refers to an arrangement with multiple accounts of which only one is a loan account. Typically, the other account is a deposit account, which can also function as a loan‑interest payment method. In this arrangement, the interest on the loan account is reduced or paid by “offsetting” it with the balance on the second account.

Notably, the deposit account may not receive any interest or interest-related benefits on its deposits or balance (as this would be non-deductible), and, in this scenario, the loan account is used for income-generating purposes, making its interest payments fully deductible. This creates a structure in which there is no taxable amount.

Under a loan account offset arrangement, the interest on income-generating loans is usually fully deductible. However, it is also possible to use the deposit account in personal, non‑loan‑related activity. For example, funds can be withdrawn from the deposit account for personal, non-income-generating purposes.

 

Let’s say Suzanne uses a loan offset account for her next property purchase. Her initial loan is $250,000 with repayments to the loan made into the deposit account. Interest is charged at the end of the month on the net balance between the loan account and the deposit account. Therefore, if she makes repayments of $100,000 that year into the deposit account, her net balance will be $150,000 and she would pay interest on this amount as this is the net balance between the loan account and the offset account. She would be entitled to deduct interest incurred on this net balance.

However, the next year, Suzanne withdraws $100,000 from the deposit account for the latest auto. Assuming she doesn’t make any other payments back into the deposit account, she would be entitled to deduct the interest that she pays on the entire original loan of $250,000.

Deductible Penalty Interest Payments

When interest is paid on penalty amounts, such payments are considered as mortgage discharge expense. The ATO will allow deduction of penalty interest payments on a rental property loan under the following conditions:

1. If the loan is secured by a mortgage over the rental property and the payment goes toward the discharge of the mortgage, or
2. If the payment is meant to satisfy a taxpayer’s recurring obligation to pay interest on the loan.