When approaching a bank or other intermediary for the purpose of borrowing funds, they may advise a structure that is easy for them and meets their internal requirements. This is not necessarily, and often times is exactly the opposite of, how we would advise you on structuring loans in order to maximise tax deductions and minimise compliance costs. You may be saving a few hundred dollars in bank fees now, but what could it cost you over the term of the loan?
In order to maximise tax deductions, lending should generally sit in the same entity as the asset that produces income. For example, a loan taken out to purchase a rental property should sit in the entity that purchases the property. While you may get a small deduction for your home mortgage interest through a home office claim, you will get a full deduction of mortgage interest on a mortgage used to purchase a rental property. (Please note that there are special calculations required where the rental is a mixed-use asset, i.e. rented for parts of the year and used by family during other times of the year). The structure is especially important if you are purchasing a new home and keeping your old home as a rental. Getting the ownership and lending structures correct at the start can help to keep legal and accounting costs to a minimum going forward.
If you have existing lending against an income-earning asset, i.e. a rental property, and wish to drawdown additional funds for private use, instead of topping up the rental loan it is advisable to drawdown a separate loan which you can pay off faster than the rental mortgage. Having separate lending for separate items allows repayments on each loan to be structured differently in order to pay down the private loan faster than the tax deductible loan. For example, you could choose to make the personal loan non-table and the deductible loan interest only, in order to minimise personal interest while maximising your tax deductions. If you top up a deductible loan then for the remaining lifetime of that loan your accountant will need to calculate the percentage which is deductible vs the percentage which is private. This extra accounting can add cost unnecessarily.
Clients often get confused about how security for a mortgage influences interest deductions. It is not the property that a loan is secured on that determines an interest deduction. It is the use of the money borrowed that determines whether the interest will be deductible.
If you are looking to borrow money to purchase a new rental property or to expand your business, please contact us first so that we can advise you on structuring loans in a way that will work best for you.
Erin Gibson is a Senior Accountant at UHY Haines Norton.