Question from James updated on 22nd January 2018:
We brought a rental property a few years ago with mortgage. We have been paying principal and interest and claiming mortgage interest as deductible expenses over this period of time and so the loan balance has accordingly been reduced. Let's say we have already repaid $50,000 of principal since we brought the rental property.
Recently, we are planning for a personal trip. We would like to take some money; $10,000 perhaps, out of the mortgage of the rental property.
The amount we would like to take is below the principal we have already paid and we are simply withdrawing what previously has been repaid. Please advise if this will affect our position to claim mortgage interest as deductible expense.
PS: We know we can refinance our property for more borrowing credit. However, we do not want to refinance because we do not need it. Also, although we will take $10,000 out of the mortgage, the mortgage balance is still below the purchase price of the rental property.
Our expert Mark Withers responded:
Unfortunately, the answer is not what you are no doubt hoping for.
You must look to the fundamental deductibility criteria that requires a direct nexus or link between the cost incurred and the earning of taxable income for the interest cost to be deductible. Despite having made a deliberate choice to reduce the deductible rental property mortgage the redraw of funds on this loan for a personal non income earning purpose does not have a nexus with income. That means no deduction is available for interest on the portion of debt redrawn for a personal purpose despite the debt still being below the original balance.
You would have to make an aportionment calculation when completing the tax return to exclude interest on the redrawn amount.This is one of the hidden traps of using revolving credit facilities and mixing personal redraws and loan repayments. Deductibility is lost as soon as the loan is repaid. Refinancing the loan will not fix the problem either. If the redraw is for an income earning purpose, for example, the deposit on a new investment property, the nexus with income is retained and interest deductibility is allowed. In hindsight, it may have been better to save for the trip separately without having reduced the deductible rental property loan.
In some circumstances where a rental property is held in a company structure and the shareholders have lent funds to the company in the form of contributed capital the refinancing of these sums can still derive a deduction to the company. No deduction though is available where loan accounts have been bolstered by dividends from unrealised asset revaluations.
Mark Withers and his team at Withers Tsang & Co specialise in advising on property related transactions, valuation and restructure services and tax planning.