Capitalise Property Interest

Thumbed though a copy of Ed Chan and Tony Melvin's book 'Wealth for Life' where they talk about capitalising interest on property loans under certain circumstances - in particular when the capital growth will outstrip the capitalising debt. They show calculations and factor in buffers to offer a level of safety.

This would certainly help with my cashflow problem but is the devil in the detail - what finance vehicle (loan) would they be using here?

I am looking for a viable system to cover the holding costs on my negative portfolio cashflow. Is this a viable option? What finance system is going to allow property debt to capitalise??

 

· Definitions of Line of Credit on the Web:
· The amount of credit a lender will extend to a borrower over a specified period of time.
www.paymentech.com/gloglol.do
· An agreement by a lender to extend credit up to a specified amount for a specified time for a specified purpose.
www.reinz.org.nz/reinz/public/buyers-sellers/terminology.cfm
· An agreement by a commercial bank or other financial institution to extend credit up to a certain amount for a certain time to a specified borrower.
www.propertytrek.com/l_definitions.htm
· A loan with a specified ceiling, somewhat like a credit card.
www.creditmortgagepoor.eu/Categories_Glossary_3.html
· Up to a certain maximum, consumers may borrow any amount for a specified time under a line of credit. Revolving credit accounts such as credit cards and home equity lines of credit are examples of lines of credit.
mortgages.interest.com/content/glossary/terms.asp
· Type of loan in which the borrower may draw on funds at any time, up to an established maximum limit; the borrower may borrow, repay, and borrow again, any and all of the credit extended; a revolving loan.
www.loannetwork.com/financeterms.html
· A pre-approved amount of credit a bank is willing to lend to a borrower for future use.
www.asbonline.com/customerservice/glossary.asp
· The amount of credit that may be extended to a borrower by a lender. This type of arrangement gives a borrower more flexibility in planning for operating expenses.
www.americancashflow.com/bcnucapital/Glossary.html
· A flexible loan arrangement with a specified ceiling to be used at a customer's discretion.
www.yourfinancechoice.com/index.php
· An agreement whereby a financial institution promises to lend a certain amount of money without the need to file another application.
www.ecorporateloans.com/content.cfm/loan-glossary.html
· Although not a contract, a bank's promise to lend to a specific borrower up to a pre-agreed amount during a specific time frame. Usually reviewed annually and subject to cancellation without notice.
www.hrsbdc.org/financing/glossary.html
· A commitment by a lender to lend up to a certain amount of money to a business.
biz.courttv.findlaw.com/business_organizations/starting/source/business_events/be1_9glossary.html
· A pre-established loan authorization with a specified borrowing limit extended by a lending institution to an individual or business based on creditworthiness. ...
https://www.midfirst.com/library1.asp
· Commitment by a lender to provide up to a set amount of funds during a specific period of time. Funds are drawn against this commitment as they are needed. Also called a budget loan.
www.extension.iastate.edu/AGDM/wholefarm/html/c3-05.html
· An approved loan amount that has not yet been used.
www.autotrader.com/help/glossary.jsp
· An arrangement between a financial institution (usually a bank) and a customer establishing a maximum loan balance that the bank will permit the borrower to maintain.
news.firstdata.com/glossary.cfm
· A short-term loan, usually less than one year.
www.businessfinance.com/books/StartABusiness/StartABusinessWorkbook088.htm
· A line of credit is an expressing by a lending entity of the maximum amount it is willing to lend to a particular customer over a future length of time. This amount may be borrowed in more than one draw down, without submitting a new loan application.
www.delawarecountybrc.com/glossaryterms.htm
· A loan based on the equity of a person’s property generally representing a ceiling of 80% of the property value.
www.interestrate.com.au/glossary.asp
· The maximum loan amount a consumer can borrow against in an account. As a credit line is partially or fully repaid, the consumer can borrow against the account again.
www.your-financial-advisor.com/terms.htm
· A maximum credit limit allowed by a lender to a borrower, as long as the borrower maintains an acceptable balance on account or has a good credit rating. The credit line will vary from time to time according to the changing circumstances of the borrower or the lender.
www.thinkamp.ca/glossary/
· "Line of credit" means an irrevocable stand-by commitment whereby the association or member insurer and a qualified financial institution or group of qualified financial institutions enter into a formal and binding contract in which the qualified financial institution or group of qualified ...
janus.state.me.us/LEGIS/STATUTES/24-A/title24-Asec4435.html
· An agreement by a lender to make funds available to an individual or an organization, up to a specific amount. ...
www.psfs.com/glossary.asp
· An agreement made between a lender and borrower for credit to be extended over a period of time and at a specified amount detailed in the agreement.
www.ownersandhouses.com/By-Owner-Glossary.php
· An amount of money a borrower may obtain from a bank without a special credit check. The money is generally for business purposes and the amount would not include the borrower's own home loan and other personal secured loans.
www.communitytitlefl.com/ct3.php
· credit line: the maximum credit that a customer is allowed
wordnet.princeton.edu/perl/webwn
· A line of credit is a type of credit in which a bank undertakes to provide credit to a client during a predefined period. The client may either withdraw the credit amount all at once, or make a certain number of withdrawals during the specified period.
en.wikipedia.org/wiki/Line of credit

 

Redwing, thanks for that. I'm pretty satisfied with what a LOC is. In fact I have one myself. To save me reading your reply in its entirety (ie the links as well) I suppose my specific observation was that despite the existence of my current LOC I am still required to meet the monthly commitments of the interest repayments on my loans. The chapter that I read appeared to indicate that the required interest payments could be capitalised (ie not paid at all until a later date). Perhaps I have missread it or am missing the obvious?? Is this something that others do?

 

There are some products out in the market that will let you capitalise the interest as long as you stay under your credit limit. Use google or a good broker to find out who will do it.

 

Matt1
Good luck on your investing. It was funny you should post this as I was only reading this book on a plane. I think the key to this sort of strategy is doing your due dilligence to ensure that you are not borrowing greater than the growth of the property. I could see how you could get into trouble with this strategy if you got carried away. I can also see how this strategy would apply to growth managed funds. This is how I intend to use it for the moment.

Good luck with your investing

 

Matt1
My lines of credit with Colonial/Commonwealth charge the interest to the line of credit (ie the interest is not direct debited from another savings account). This was an option I selected on the initial application.
This way you can pull your shortfall amounts (presumeably you are referring to using the line of credit to fund shortfall on a negatively geared property) from your line of credit, all interest gets capitalised to the line of credit and as long as you stay under your credit limit on the LOC you dont need to make repayments.
Another option you may like to investigate is drawing on the whole line of credit, putting that into a margin loan facility and borrow on top of that, then fund your LOC interest payments and your negatively geared property shortfall from your margin loan. This way at least you have assets with growth potential in there as well, as opposed to using just a LOC facility which is all debt.

 

Mat,

You could do this.

Assuming that you have equity in your property
1. you revalue the property to access the remaining equity.
2. you put all that equity into a 2nd LOC ( LOC2)
3. you use the funds from LOC2 to pay the interest for LOC1
4. you pay the interest on LOC2 monthly from your own funds.

This is in a way capitalising interest but is an acceptable
way of capitalising interest as in essence you are borrowing money to pay
for the holding costs of your IP.
At the same time, your LOC's are separate so you are no adding interest on interest
which the ATO does not allow.

If you wanted you could go 1 step further and deposit the rent from the IP into your PPOR loan
and save 7% or so or into a high interest savings account and easily make a taxable 5% or so.

Cheers
Bill

 

Hi Bill,

The courts have allowed capitalised interest in the past (i.e. interest on interest, or compound interest).

The Commissioner brought the matter up again in Hart's case but it was unecessary for the court to rule on this one. Maybe he was just throwing any argument, or maybe he is signalling that these arrangements are going to suffer greater scrutiny.

Until a specific case on this particular issue is heard again, the past courts' decisions stand as far as I am concerned. The courts and Parliament make the law.

Cheers,

Rob

 

Rob,

I agree, but I wouldn't want to go to court to fight the ATO
therefore I would structure my loans in a way that is acceptable to them.

cheers
Bill

 

I have two LOCs, both purely for "income generating purposes" and I don't capitalise interest; rather, I direct debit the interest from an offset account against my PPOR.

I contact my bank and start capitalising the interest (LOC2 pays interest on both LOC1 and LOC2 each month), will this be seen as a tax avoidance measure?

In other words, I understand that if I had setup this structure from the start, I would be simply capitalising the interest on the LOCs, and this would be clean with the ATO. But if I make the changes after this has been operating for a while, would I draw attention?

 

Hi Rod,

I don't see any problem provided you are in an on-going investment situtation.

The simple argument would be that you are using the money otherwise repaid in your general investing activities.

I don't believe that the ATO expects to see some clear incremental income producing activity as a result of starting to capitalise.

Alternatively, you could claim that the level of borrowing for gaining your assessable income has stretched your resources (maybe you had initially underestimated the costs), but since you are committed to repay the interest in the long term then it should be deductible.

Cheers,

Rob

 

Rod_WA,

I don't believe that you will draw any attention at all.
You are not trying to avoid paying tax but rather to increase your abillity to hold the asset.

Your structure above IMO (and I am not an accountant)
is not different to obtaining a loan to run a business

A lot of people if they didn't have this structure would be unable to hold the asset and the ATO would miss out on the nice CGT they would otherwise get.

Cheers
Bill

 

Hey all and thanks for your input.

BV, would an example of your 4points be as follows? -

Assuming that you have equity in your property Lets assume the property portfolio is valued at 1million and the debt is $650k
1. you revalue the property to access the remaining equity. So 1mill @ 80%=800k less the 650k debt
2. you put all that equity into a 2nd LOC ( LOC2), so 800k - original debt of 650k = $150k into LOC2.
3. you use the funds from LOC2 to pay the interest for LOC1 - Interest on LOC1 would be calculated at say $650K * 8%=$52k
4. you pay the interest on LOC2 monthly from your own funds. Funds in LOC2 (150k) are used to pay the interest on LOC1 (52k) and my own cashflow/funds are used to meet the interet charged on LOC2. Am I on the right track? This system is of course great while the portfolio continues to grow which is as others have suggested, why it would be better to utilise the equity to purchase an income source through managed funds etc.

 

Matt1,

Yes that's the idea but remember that if LOC2 is paying the interest for more than 1 IP you will need to separate the amounts for your tax return.

Your accountant can do this but you'll need to assist him
so if for example you are paying the council rates use the street name of your IP as the reference. i.e. Rates-Miller st.

Note that if you start spending money from LOC2 for various other investments it will become difficult to keep track of the interest of each investment.

Also, I wouldn't go spending all the money.
Why don't you put aside $50K or so for a rainy day in case (touch wood) you got sick or lost your job, etc etc.

Cheers
Bill

 

another situation:

a split loan facility, secured over a property..
a new LOC1 is taken out, also secured over the property.

Funds from LOC1 are then used to pay the repayments on the Split loans, as well as a little bit used to buy some shares.

Repayments on LOC1 come from rental income and pocket.

nothin wrong with this, and ll the interest is fully deductible.. ?

 

Just trace the use of the borrowed funds.

Provided any borrowed money is used to gain assessable income, then no problem.

So if your split loan is one account for investment, and one account for private use then you must apportion and not claim borrowings to repay any private loan.

Can I just ask why you are taking out further loans over the same property to repay loans secured over the very same property ? Is it just a refinancing exercise with a better interest rate ?

Cheers,

Rob

 

Until you sell one of the assets. If you sell then you could be in some problems as you cant easily repay that part soley, the loan will then become part deductible and part non deductible (i think)....

 

TheCamel,

Were the money of the split loan used to buy the same property?
if yes, then I see no problem with it.

Interest on the money pulled out of LOC1 will be deductible
as long as they were used to pay IP expenses or used for other investments.

You will need to separate the amounts and to calculate the % of interest that applies to each one of your investments. Your accountant can do this but you need to keep good records.

Last point I want to make is that the above are my opinion only
and the posts only aim to show what I would do if I was in the same situation
and are not professional advise.

Cheers
Bill

 

true, but the accountant can calculate the amount of interest
that applies to the non deductible portion.
As long as you keep records then it's not a problem.
Cheers
Bill

 

Until you get his fee...

As been said before its best to have 1 LOC per property however we all know thats not possible, so this is the best way

As long as you dont try and calculate the capitlised interest portion it shouldnt be to hard (therefore not expensive) for the accountant to complete...