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The BOWMAN
25-03-2007, 11:21 AM
Hi, I have a newbie question regarding to how much mortgage interest can be counted as cost. Say I bought a house $300k a couple of years back and it is used as a rental. If I have mortgaged the full price which is $300k and having an interest only loan at a rate say 8%, then I will pay $24K interest per year. This $24K is counted as cost. After two years, if the house has a new RV of $400k and I go to the bank to refinance the house with a $400k loan, still interest only (8%). Then the interest per year becomes $32k. How much of the interest can be counted as cost? $32k or only up to $24k?

I couldn't find an clear answer. If you know it for sure, could you advice?

Halebop
25-03-2007, 11:44 AM
Hi Bowman,

Rather than the purpose of the property, tax deductibility depends on the purpose of the loan.

Your 1st $300,000 was used entirely to fund a rental accommodation business. The costs associated with that business ($24,000 interest) are fully deductible.

If you subsequently borrow an additional $100,000, the additional interest is only deductible if the cost is a legitimate business expense.

So if you put the $100,000 towards a holiday, groceries and other bills plus some new toys at home, bad luck. As an aside I suspect you might even open yourself to being deemed an asset trader if you make a habit of drawing down funds against a rising asset value.

But if you put the $100,000 towards a small business, share portfolio or another rental property, the interest is a legitimate cost of doing business and will be deductible.

The BOWMAN
26-03-2007, 08:16 PM
Thanks for your reply. Halebop.

That is what I thought it would be. But then I am confused thinking that if I sell the house to myself for $400k and get a new mortgage for the new price, then the interest on all $400k would become tax deductible...

Halebop
26-03-2007, 08:52 PM
You're welcome Bowman.

The strategy you are mulling will work perfectly as long as you aren't caught.

If IRD think the transaction is "structured" for the purpose of minimizing tax they can disallow deductions that you attempt with the new structure / transaction. Alas the onus is on you to prove otherwise rather than them to prove evasion, which will leave you with little room to move (and probably a good deal worse off).

Some promoters offer the concept of selling your house to a trust or LAQC, paying market rent and having the entity deduct interest as a "legitimate" expense. IRD disagree with this interpretation as per the 2nd paragraph.

Personally I think if you have alternate assets like shares or whatever, as you sell them through the normal course of portfolio adjustments you should apply the funds to the owner occupied mortgage and then draw down on mortgage financing when you purchase replacements. It gets you to a similar destination a little slower but without giving IRD recourse.

The BOWMAN
27-03-2007, 09:46 PM
Man! All these years I have been paying interest for the money spent on shares!

Serpie
08-04-2007, 09:34 PM
Halebop,
If I understand you correctly you've said that if the extra $100k is put towards a share portfolio then that would be a legitimate business expense. Would shares not be classed as assets, and therefore taxed in the same way as cash (or any other asset)?

I have a LAQC that holds rental properties, so I'm interested in any tax advantages that can be offered with regard to shares.

Cheers
Serpie

PS - Bowman - please note that "tax avoidance" is about as popular as "tax evasion" with the IRD.

Halebop
08-04-2007, 11:27 PM
Hi Serpie,

I'm no tax attorney and consequently let other people sort my taxes. Before getting caught up in tax I personally favour the concept of ensuring the investment itself stacks up on it's own merits.

However, in the example the shares themselves would provide no direct tax benefit (under the new regime there may be a tax cost if the shares don't fall within the narrow field of NZX or ASX500'ish). Borrowing to purchase them should result in the interest costs of those borrowings becoming deductible, in the same way properly structured interest cost on a business owner's capex is normally deductible. As always, deductions for a net short-fall are only useful if there is income to deduct from in the first place.

In terms of an LAQC, I think you need to be asking yourself what is the intentions of your actions? If you are borrowing more money at 8.6% to purchase shares yielding 4.2%, the answer from IRD's perspective may be that you are structuring the purchase to reduce your taxable income? Thus we might be entering the ambiguous zone between avoidance and evasion. I suspect the original example was a fraction safer because it was a "normal course of business" sale and subsequent purchase. The only difference was that the purchase was funded via redrawing the mortgage. There are also a number of assumptions in that suggestion around structure and income that might not be useful to everyone.

Snapper
09-04-2007, 07:50 PM
quote:Originally posted by Halebop


In terms of an LAQC, I think you need to be asking yourself what is the intentions of your actions? If you are borrowing more money at 8.6% to purchase shares yielding 4.2%, the answer from IRD's perspective may be that you are structuring the purchase to reduce your taxable income? Thus we might be entering the ambiguous zone between avoidance and evasion.

Hmmm..if that was the case then just about every mortgage on rental property in NZ wouldn't be tax-deductible. What you have to consider is long-term potential income. If you think that the income will rise over time so that the investment will be tax-positive then I doubt there would any question of avoidance.

Serpie
09-04-2007, 08:49 PM
Halebop,
For someone who says that they're not a tax attorney - you go ok!
I believe that I'm maximising my LAQC arrangement at present, so will refrain from clouding things with a share portfolio in the LAQC's name. Will keep that seperate.
Thanks for the clarification.

Steve
10-04-2007, 09:52 AM
quote:Originally posted by Snapper


quote:Originally posted by Halebop


In terms of an LAQC, I think you need to be asking yourself what is the intentions of your actions? If you are borrowing more money at 8.6% to purchase shares yielding 4.2%, the answer from IRD's perspective may be that you are structuring the purchase to reduce your taxable income? Thus we might be entering the ambiguous zone between avoidance and evasion.

Hmmm..if that was the case then just about every mortgage on rental property in NZ wouldn't be tax-deductible. What you have to consider is long-term potential income. If you think that the income will rise over time so that the investment will be tax-positive then I doubt there would any question of avoidance.

The key to deductability is the intention to generate income. If you borrow at 8.6% to generate 4.2%, that would be acceptable as long as the borrowings specifically relate to the income stream. There is no requirement to make a profit...

Snapper
10-04-2007, 10:01 AM
quote:Originally posted by Steve


quote:Originally posted by Snapper


quote:Originally posted by Halebop


In terms of an LAQC, I think you need to be asking yourself what is the intentions of your actions? If you are borrowing more money at 8.6% to purchase shares yielding 4.2%, the answer from IRD's perspective may be that you are structuring the purchase to reduce your taxable income? Thus we might be entering the ambiguous zone between avoidance and evasion.

Hmmm..if that was the case then just about every mortgage on rental property in NZ wouldn't be tax-deductible. What you have to consider is long-term potential income. If you think that the income will rise over time so that the investment will be tax-positive then I doubt there would any question of avoidance.

The key to deductability is the intention to generate income. If you borrow at 8.6% to generate 4.2%, that would be acceptable as long as the borrowings specifically relate to the income stream. There is no requirement to make a profit...


If you explained to the IRD that it was your intention never to make a profit then I think it unlikely that they would allow a deduction for interest.

Steve
10-04-2007, 10:43 AM
quote:Originally posted by Snapper

If you explained to the IRD that it was your intention never to make a profit then I think it unlikely that they would allow a deduction for interest.

What I said was that there is no [u]requirement</u> to make a profit. Your [u]intention</u> has to be to generate income in order to claim the deduction...

As published by the IRD:
Example 1: An individual borrows $10,000 at 10% p.a. to finance a purchase of shares in a company. No dividend is paid in the 5 income years following the purchase of the shares. The taxpayer pays interest on the loan in each of the five income years. Is the interest deductible?

Application: The individual can deduct the interest in full in each of the 5 income years because the capital is used in each year in gaining or producing assessable income. Even though the company paid no dividends, the interest will be deductible provided the company has no restriction in its articles of association preventing the payment of dividends in the future.

The interest is deductible as long as the shares are expected to earn assessable income. There is no requirement that assessable income be produced in the year the interest deduction is claimed.

Snapper
11-04-2007, 12:05 PM
Fair enough

Halebop
11-04-2007, 12:48 PM
quote:Originally posted by Steve

What I said was that there is no [u]requirement</u> to make a profit. Your [u]intention</u> has to be to generate income in order to claim the deduction...

As published by the IRD:
Example 1: An individual borrows $10,000 at 10% p.a. to finance a purchase of shares in a company. No dividend is paid in the 5 income years following the purchase of the shares. The taxpayer pays interest on the loan in each of the five income years. Is the interest deductible?

Application: The individual can deduct the interest in full in each of the 5 income years because the capital is used in each year in gaining or producing assessable income. Even though the company paid no dividends, the interest will be deductible provided the company has no restriction in its articles of association preventing the payment of dividends in the future.

The interest is deductible as long as the shares are expected to earn assessable income. There is no requirement that assessable income be produced in the year the interest deduction is claimed.

Steve, I've recently been down this line of reasoning with my accountants and a tax attorney friend. While I'm sure there are examples out there of people who have got away with it (or who have at least not been speed ticketed yet) LAQC's are required to meet additional definitions to a simple intent to generate income. Where affairs appear to be structured for the intent of reducing taxable income, IRD may object on the grounds of avoidance. Therefore the paper trail had better indicate a clear line of reasoning outside of tax mitigation, hence my earlier reference to "normal course of business" when executing sales and purchases that effectively restructure ownership and deductibility.

As an aside, I suspect LAQC rules could substantially alter, including being done away with altogether, if anything like the mooted limited partnership laws come into being.

Serpie
12-04-2007, 06:28 PM
I think the only thing saving LAQC's is that most of the people who make the laws have an LAQC themselves. Same with family trusts. These guys will be in no hurry to cut their own throats.
(quick - someone change the subject before we start talking politics!)

Halebop
12-04-2007, 09:29 PM
quote:Originally posted by Serpie

(quick - someone change the subject before we start talking politics!)

...religion or gaming consoles?

Disclosure: XBox 360

Steve
15-04-2007, 08:23 AM
quote:Originally posted by Serpie

I think the only thing saving LAQC's is that most of the people who make the laws have an LAQC themselves. Same with family trusts. These guys will be in no hurry to cut their own throats.

I agree Serpie.

I made a similar comment in another thread. They are just making noises to worry people IMO

Dean Letfus
16-04-2007, 01:07 PM
Most tax specialists are predicting that they will ping LAQC's but thet they will probably grandfather the regime.
So all that will mean really is that new investors will need some more complex structures to cope going forward. There will always be a solution.