It is common to see loan structuring mistakes with about 90% of the clients I see. One of the most common mistakes is ‘mixing’ loans. This occurs where one loan account has been used for more than 1 purpose and often happens when redraw is used on a loan, but can also happen when the one loan is increased.
Tom has an $80,000 loan with ANZ on a $100,000 property. He has paid the loan down to $60,000 but still has $20,000 available in redraw. The original loan was used to purchase his owner occupied property. Tom goes and buys an investment property and has the good sense not to use his cash but borrows the $20,000 from the original loan by redrawing it and using it as deposit.
Tom now has a mixed purpose loan. No real problem so far as the 2 purposes can be easily worked out and interest apportioned between them.
But problems can arise in the future.
If Tom’s loan is PI then he will be paying down the investment portion with every deposit he makes. The loan being one pool of debt he cannot segregate the repayments so they come off the non-deductible portion first. So every deposit he makes causes him to reduce his tax deductions which means he is losing money by paying more tax. He is essentially throwing money away.
Solution – split before using.
It will also be very difficult to calculate the portions of the loan. Each deposit made would come off both portions of the loan in relation to the percentage at the time of the portions at the date of deposit.
20/80 = 25%. So 25% of the loan relates to investment and 75% to private purposes. If the deposit into the loan is $100 then $25 must come off the investment portion and $75 off the private portion. Simple for the first deposit, but what if $328.77 in interest is charged for the month. 25% of this relates to the investment portion.
It would be very difficult to work out over a short period. But with some people this has gone on for many years and it would be very difficult to work out.
Solution – split before using.
Another problem is the offset account. Since it is one big loan Tom would be offsetting the investment portion too. Say Tom had $60,000 cash. He would still be paying interest on $20k yet 75% of this would be private interest and therefore not deductible.
Solution – split the loan before you use it. Tom could have had 2 splits of $20,000 and $60,000 he could set up the offset on the $60,000 loan and pay no non-deductible interest at all.
Sale Time. If Tom were to sell either property he would then need to do some readjusting. If he sold the main residence he would have to be careful about paying out the investment portion (topic of a future tax tip). Paying this out would be necessary because the loan is secured by the main residence. But this would cause Tom to lose deductions and also to have less cash available for his new main residence. Fortunately there may be a way around it in most cases. This issue would occur whether the loan was mixed or not. But it is only possible to rectify this if the loan is split before it is paid off.
However the ATO do allow a concession for these situations where the property relating to the loan is sold. See Tax Tip 55.
There are also issues with mixed loans where all portions of the loan relate to investments, albeit different investments. Tax Tip 20A An issue with mixed purpose loans where both portions are investment.
So what to do if you have mixed loans?
Fortunately the ATO allows mixed loans to be unmixed. Rolf says you cannot unscramble an egg, but the ATO allows you to notionally unscramble a mixed loan.
You must work out the relevant portions on a reasonable basis and the loan can then be split. Splitting means each loan portion will end up with a separate account number so they can be distinguished from each other.
Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au