Tax structure for two properties
Question from Nicky updated on 7th January 2015:
We currently own two mortgage free homes, a rental in Auckland ($430 per week) and the other we live in is in Havelock North (potential rental of $370). We also have $100,000 in savings, after the sale of a larger rented property (the difference was used to pay off the above mortgages). The properties have CVs of $380,000 and $350,000. We would like to purchase a new home for ourselves which we assume would require us to re-mortgage the above properties, I understand that we can't claim any interest payments on the rentals if the money lent relates to the purchase of a different property, could you clarify this for me and advise the best way to structure our debt in our situation? We are looking to spend around $500,000. We are a couple with new born and on one income of $70,000. Thanks.
Our expert Mark Withers responded:
Dear Nicky. The dilemma you face is relatively common. You are correct that no deduction for interest is available against rent from the existing properties where the loan money is in fact used to buy a private asset. The interest expense simply doesn't meet the deductibility test that requires it to be incurred in relation to income for it to be deductible. Confusion is common on this point, especially where the properties that are producing the rent are the ones that are actually mortgaged to provide the security for the home loan. The security though, in this case is a red herring. One way to solve this is to sell the rental properties and use the proceeds to buy another home. Having done this the home could be mortgaged to enable borrowed money to be raised to fund the purchase of another rental property. If you specifically wish to keep the rentals you already have you could consider a restructure that would involve the formation of a separate entity, perhaps a look through company, that would contract to borrow money to buy the rental properties from you. With the proceeds of this sale you would have cash available to purchase the new home. From the companies perspective, the interest it incurs then meets the deductibility test because the money it borrowed was used to buy income earning properties. If the company produces a loss, which is by no means certain given you may only end up with $500,000 of debt, the look through company (LTC) allows this loss to be flowed to its shareholders where it can be offset against other income. Given the significance of a restructure such as this you may also consider widening the brief to include overall estate planning, perhaps a trust for the freehold home, gifting of your capital into it and how the shareholding of the LTC should be structured and what matrimonial issues this creates. Widening the agenda on this beyond just a tax driven re arrangement also lessens the possibility that the entire exercise could be view as a dreaded tax avoidance arrangement. IRD have signalled these types of restructures are not avoidance in their view but none the less the more commercial basis there is for the restructure the better.
Mark Withers and his team at Withers Tsang & Co specialise in advising on property related transactions, valuation and restructure services and tax planning.