The tax office issued a draft determination last year on the topic of using a capitalising line of credit to fund interest repayments on an investment property whilst using the rent to pay down personal debt. They’ve now finalised that determination and there are a few important points to consider as a result.

If you have the time and inclination, you may be interested in reading the full TD 2012/1 first, which you can find here.

The tax office start out by exploring the idea of using a LOC to fund your investment expenses including interest on the main investment loan/s, while directing all income (including rent on those same investments) into your personal debt (commonly secured against your PPOR). The balances on the personal debt decrease, while the investment debt (and thus deductions) increase accordingly… So, it’s not hard to see why the tax office might be a little concerned, particularly with the number of spruikers promoting the scheme recently.

Importantly though, they immediately concede that technically the interest on the line of credit MUST be completely deductible if the investment debt was also used purely for income-producing purposes. This is well accepted and makes good sense. In many ways, this is similar to a business claiming the interest paid on an overdraft facility used to make repayments on other loans.

However, the tax office then raises the issue of whether Part IVA (the general anti-avoidance provision) can apply to the arrangement to deny the interest deduction on the LOC.

In the past, many taxpayers have argued that the dominant purpose of the arrangement is to pay of their home loan sooner. What this ruling suggests though is that the tax office will look at the ‘bigger picture’ when assessing the application of Part IVA and that as such, they may determine that the purpose of avoiding tax is an equal, and perhaps higher, priority than paying off the home loan.

The biggest problem with using the ‘paying off our home faster’ excuse is that in many cases, the LOC is secured by your PPOR and so even with the personal debt paid off, the bank won’t release security as you still have a sizable debt against the property. The tax office also hints of an expectation that a “reasonable” amount of rental income should be contributed towards the investment debt, without suggesting what such a reasonable amount might be. It would certainly be a bold statement if they started directing how taxpayers need to use their cashflow…

In our view, the tax office are trying to make their position clear without actually stating that the arrangement will definitely fall foul of Part IVA. The answer given in the ruling appears to be deliberately vague; they don’t say that the anti-avoidance provision WILL apply; they only state that a supposed dominant purpose of paying off the personal debt first doesn’t restrict them from denying the claim if the reasons for wanting to pay off that personal debt include gaining a tax advantage.

So, what does all of this mean then?

The bottom line, in our opinion, is that to claim the interest on a capitalised LOC a taxpayer will need genuine commercial (ie, not personal) reasons for doing so… as we have stated was the case all along. The tax office have made a clear point that they do not like the practice, and so you should be prepared to fight in the event that you find yourself on the wrong end of an audit. It can be done, certainly, but it needs to be structured very carefully and with the right intentions from day one.