How much mortgage interest can be counted as cost?

[The BOWMAN]

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]

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]

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]

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]

Man! All these years I have been paying interest for the money spent on shares!

[Serpie]

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]

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]

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]

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]

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...