Tax Q&A: Refinancing and claiming mortgage interest

Q: We plan to move out of our principal place of residence in about 12 months, after which we will rent it out. We want to refinance this year to release some equity so we can purchase a caravan and finance holidays.

My question is: if we refinance now while we’re still living in the property and then later rent it out, can we still claim the mortgage interest on the whole loan, or only part of it? 

Thanks, Claudia

A: A common question for investment property owners is the relationship between types of borrowings, the security for those borrowings, and tax deductions. The general principle is that interest is a tax deduction to the extent that it relates to borrowings used to acquire income-producing assets.

If you borrow money solely for the purchase of an investment property, the interest on the loan will be 100% tax deductible. However, if the property is rented out for half the year and used privately for the other half, the “extent” of the income-producing purpose is 50% and you can claim 50% of the interest on the loan.

It is only the purpose of the borrowings that determines income tax deductibility. The legislation does not consider the security for those borrowings, or what the fi nancier has called the loan. You could have a loan solely to purchase an investment property, which is secured by the family home and called a home loan by the fi nancier. This loan would still have interest that is 100% tax deductible, as only the purpose of the borrowing is taken into account.

The same principle applies to the situation you have outlined. You are contemplating new borrowings that will be for a private purpose. The fact that those borrowings will be added to a loan used to buy an income-producing property is irrelevant. Deductibility is determined by the extent of borrowings used for the acquisition of the property. The additional borrowings for a caravan and a holiday are not for a deductible purpose, so that part of the interest will not be tax deductible.

If you proceed as you have proposed, your loan will not be entirely for investment purposes, with the benefit of 100% tax deductible interest when the property is rented out. A calculation will instead need to be done to determine the extent of your deductible borrowings, which is the percentage of the loan balance before the private draw-down to the total loan amount afterwards. The interest on this percentage will be tax deductible. 

Aside from the impact on your tax deductions, you might reflect on whether it is desirable to have longterm borrowings to finance a holiday and a depreciating asset. There is some merit to aligning the length of your borrowings with the life of the asset being acquired. Car loans are typically three to fi ve years for this reason. Another thought is whether you really want to use up your equity, which you could use for real estate purchases, when other forms of finance that don’t do that are available for your private expenditure.

Need to know

• The purpose of borrowings is what determines income tax deductibility.
• Deductibility is related to the extent that the borrowings are used to acquire an income producing property.
• There is some merit in aligning the length of borrowings with the life of the asset being acquired.

   

Daniel Rands

is partner at PKF Chartered

Accountants and Business

Advisers Tasmania