Interest paid is usually the largest tax deduction against rental property income, and in a lot of cases creates an overall loss, which may lead to an overall reduction in income tax payable. Taking out a loan to buy an investment property and claiming the interest charged as a tax deduction seems to be a simple proposition, however, as with anything in relation to tax, there are some complications. It is crucial to be aware of a few rules, especially when the expectation of tax deduction creating tax savings is one of the main deciding factors in purchasing an investment property.
The Australian Taxation Office (ATO) recently conducted a review of over 300 rental property tax schedules and found errors in nearly 9 out of 10. Incorrect interest expense deductions were one of the most common errors found.
How mistakes happen – multi-purpose loans
From the outset, it is important to have evidence showing that the funds, on which interest charged is claimed as a tax deduction, were used to purchase the investment property, fund the improvements or even used to pay for holding costs, or were used to re-finance such loan(s). There must be a clear connection between borrowing and the use of funds.
Securing a property against a loan does not automatically make the interest deductible. Unfortunately, this can make some clients unhappy hearing that the interest may not be tax deductible against the rent, if the funds were used for another non-income producing purpose.
It is very important to be careful when a loan is used for an investment property and another purpose. Having such 'split loans' is not ideal from a tax return preparation point of view, but sometimes is necessary or convenient for funding purposes. In such cases, calculation of deductible interest becomes more complicated.
Whilst funds withdrawn can be for a particular purpose, in general, any repayments to the loan account cannot be segregated to a particular purpose (subject to certain exclusions), and repayments will apply equally across the entire value of the loan. This can lead to a very inequitable outcome, as explained in the example below.
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Example
In 2010 Chris purchased an investment property, and a loan totalling $500,000 was taken in relation to the property purchased.
Later in 2015 Chris decided to purchase some shares listed on the ASX, and rather than applying for a new loan, he chose to drawdown further on the already existing loan. With a loan balance of $400,000 after repayments, Chris drew down an additional $75,000 for the purchase of the new shares.
In 2015, Chris also decided to undertake some landscaping work at his main residence and drew down an additional $25,000, taking the value of the loan back up to $500,000.
As a result, between 2010 and 2015 (prior to the drawdown), interest charges on the loan are fully deductible, assuming Chris had made the property available for rent at all times.
From 2015, Chris must apportion the interest charges on the loan balance as follows:
| Loan Amount |
Purpose |
Deductible? |
| $400,000 |
Investment Property |
Yes - against rental income |
| $75,000 |
Shares |
Yes - against dividend income |
| $25,000 |
Landscaping - main residence |
No - private expense |
After realising this is too complicated to maintain, in 2016, Chris decided to repay the $25,000 to the bank in relation to landscaping, as he assumed the loan would then be 100% deductible again.
Whilst the assumption is reasonable, the ATO look at this differently. Generally, the $25,000 repayment cannot be applied directly to the purpose, and the repayment is applied equally across all purposes. The loan balances are then as follows:
| Loan Amount |
Repayment |
Adjusted balance |
Purpose |
Deductible? |
| $400,000 |
-$20,000 |
$380,000 |
Investment Property |
Yes - against rental income |
| $75,000 |
-$3,750 |
$71,250 |
Shares |
Yes - against dividend income |
| $25,000 |
-$1,250 |
$23,750 |
Landscaping - main residence |
No - private expense |
| $500,000 |
-$25,000 |
$475,000 |
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The above example can be addressed by refinancing the loan; however, complications can arise where there are multiple purposes, advances and repayments. Based on our experience where one client ended up with five loans – all used for various properties and other assets, including using one loan to repay another – it was a relatively expensive exercise to conduct the detailed calculations. We assisted the client in getting the loan refinanced with the bank to simplify the arrangements and ensured their interest claims were maximised.
Another approach is needed if a line of credit facility is used to fund property, followed by many transactions for various other purposes. Calculations are more complicated, but monthly averages can be used according to the ATO Taxation Ruling 2000/2.
Finance options have other considerations in addition to tax, but a loan for one purpose, with a possibly offset linked account, is always worth looking into. This option will much more likely guarantee full deductibility of interest assuming the funds were used for income producing purposes.
How mistakes happen – other ATO triggers?
Care must be taken when interest is prepaid before 30 June or accrued in one year, as banks sometimes charge interest for June in July, so the deduction is calculated correctly in the current and following years.
Finally, interest may not be deductible due to changes in circumstances (e.g. the property is not available to rent for a period; the property is rented below market rate; the property is used for private purposes). It is very important to keep track of such changes and record amounts of interest not claimed, as this helps in correctly calculating possible gains or losses on the subsequent disposal of property.
Next steps
From experience, most of these decisions are made directly with banks and/or mortgage brokers. That said, to ensure you won't be stung from a tax perspective prior to making these decisions, it is always worth checking with your local Moore Australia advisor. Careful planning at the beginning will save you time and money in the long run.
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