Interest deductibility problem

Question from Karl updated on 28th June 2017:

I am moving city and plan to rent my existing house and buy a new house when I move. My current house is owned by my wife and I through a Trust structure. My wife does not currently generate income.

I will need to mortgage my existing house to buy the new house but would expect not to have to include the new house in the mortgage security.

I am keen to understand the best strategy and structure to minimise tax on rental revenue. Am I able to match the interest expense of the mortgage against the rental earned on the rental property?


Our expert Nick Ashford responded:

One of the most important things to understand about interest deductibility is that your security arrangements for the loan do not determine the deductibility of interest with the IRD. It is the use to which the borrowed funds are put that determines whether interest can be claimed.

So, where the Trust borrows money secured against your old house but uses it to buy a house that you will live in personally there is no direct link between the borrowed money and the acquisition of a property that will derive rental income. This leaves the Trust with taxable income from the house that you are moving out of where your equity is and no deduction for interest on the new loan that purchases the new home.

There may be several ways to solve this problem. The old home could be restructured into another entity that borrows to buy it from the trust. It would also be worth determining whether the Trust still owes you money personally. If it does you could demand the repayment of your loan and refinance this.

At the extreme end of the fix scenario you could even sell your old home to repay the new debt and then borrow against the new home to buy a replacement rental property. This option often looks a whole lot more attractive if the rental yield on your old house is low and it isn't necessarily the property you would choose to buy again if you were looking for a rental.

Nick Ashford and the team at Withers Tsang & Co specialise in advising on property related transactions, valuation and restructure services and tax planning.

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