Mortgage providers are preparing to make home loans tax-deductible in a move that could revolutionise home ownership and wealth-creation strategies for investors.
After an important legal win against the Australian Taxation Office last month, a number of lenders are relaunching so-called split loans designed to substantially reduce the after-tax cost of buying both a private home and an investment property. The investment could, of course, also be in shares or a business. The ATO wants the High Court to rule on the loans, but mortgage providers are going ahead regardless.
A split loan is one mortgage split into separate accounts - one for private purposes, such as a home, and another for an investment property, shares or other income-producing assets. All payments of interest and principal on the investment account are deferred until the home loan is paid off, which means the home loan can be paid off twice as fast. This is because interest is calculated on the overall loan size but offset on the home loan account.
At the same time, compound interest - the interest on the interest - is fully tax-deductible on the investment account, resulting in a much bigger tax deduction even though total interest charges are no greater than on a standard loan.
(The products in question are not to be confused with mortgage products that allow borrowers to "split" loans into fixed and variable interest rate components.)
The benefits arise because interest is switched from the home account to the investment account, changing from non-deductible to tax-deductible in the process. It's as close as a mortgage provider has come to offering a tax-deductible home loan - and the ATO almost admitted as much last week.
"By linking the home loan with the investment loan, interest that could reasonably be expected to accrue on the home loan accrues instead on the investment loan," acting tax commissioner Michael D'Ascenzo said in explaining why the ATO wanted the High Court to hear the case.
Split loans were very popular until the ATO became alarmed about the potential blowout in lost revenue due to the tax claims for compound interest, which accelerate the tax benefits of negative gearing. It issued an adverse public ruling in 1997 and funded a test case which resulted in last month's 3-0 judgement in favour of taxpayers.
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At the centre of the court action is a Canberra couple, Richard and Trudy Hart, who five years ago refinanced their old house, let it and bought a new house. They borrowed $300,000 via an Austral Mortgage "wealth optimiser" loan, split into home and investment accounts. They directed all payments to the home loan, making no interest or principal payments on the investment account.
As a result, the mortgage on the new house, with its non-tax-deductible interest, was paid off in six years instead of 25, while tax-deductible interest on the investment loan, relating to the old house, compounded, increasing the tax deduction by $170,000 in the Harts' case.
Justice Graham Hill said the split loan was "certainly explicable only by the taxation consequences" and clearly created greater tax deductions for interest than would otherwise have been available. Nonetheless, he said the Harts' main purpose was to finance the two properties, not to avoid tax. Justices Richard Conti and Peter Hely agreed, citing John Howard, who 19 years ago, when he was federal treasurer, introduced PartIVA of the general tax avoidance section of the Tax Act, and said the provision was confined to "schemes of the blatant or paper variety".
Vicky Edema, managing director of Austral Mortgage, which developed the Harts' loan and claims it pioneered split loans, says the win makes it easier for investors to pay off their home loan while building wealth through other assets. "Three eminent justices confirmed our legal advice in their Full Bench finding," Edema says.
She says the ATO's High Court action is likely to fail and borrowers should "position themselves now". She argues that there is no downside. Although the ATO will continue to deny the extra tax deductions for the compound interest component, Edema claims borrowers won't lose out even if the High Court hears the case and rules against taxpayers. "If the decision goes against us, borrowers are still in a good, well-priced, flexible product," she says. "If we succeed, they've paid more off their home loan and have capitalised interest they can claim on tax."
Edema says the ATO position is inequitable because similar tax benefits to those available under a split loan may be achieved by smart borrowers who use two lines of credit from separate borrowers. "This product simply makes these options more accessible to the average mum and dad," she says.
Brad Seymour, head of product at Wizard Financial Services, says Wizard is "watching developments closely" and definitely intends to re-enter the market "when the time is right".
"There is no doubt that there is a real market for this kind of product in Australia because so many of us use the mortgage as our primary platform for wealth creation," Seymour says.
"Borrowers need to know that the appeal for special leave and the possibility of High Court action could [create] another 12 months of doubt around this product consideration."
Deloitte tax partner and former ATO deputy chief tax counsel Michael Bersten says the ATO, like anyone else, has about a one in 10 chance of getting the High Court to hear its appeal.
If the ATO is unsuccessful, Treasury could also seek to have the law changed. But Bersten says that could be "challenging" in an environment where the Federal Government appears "resistant" to introducing more specific tax-avoidance rules.
"The actual arrangement involves a very basic deduction provision, so you'd probably need a specific anti-avoidance provision," Bersten says.
Still, he advises caution. "Investors also still have to pay the interest some day, so you need to be aware of the risks if the tax benefit is denied," he says.
Les Szekely, director of Horwath Sydney, says investors should determine whether the product works for them without the tax effectiveness. "If you go into them as a reasonable product without the tax benefit, there's no downside," Szekely says.
George Zakher, who was involved in developing the Austral product and is now a director of mortgage provider New Loan, says the company plans to launch its new Tax Smart line of credit - a variation on the split loan - despite the ATO move.
"The High Court application may not be heard for nine months, but in the meantime a borrower that has this structure is in no worse a position," Zakher says.
"They're setting themselves up in a tax-effective structure and not paying any more for it. The interest rate is exactly the same as any standard lines of credit."
However, Zakher says borrowers must get their own advice and he does not advise unwinding existing loan structures, which may trigger penalty fees.
"For someone undertaking a purchase or looking at refinancing anyway, there is no downside in switching," he says.
Lisa Montgomery, chief executive of consumer information provider Infochoice.com.au, says borrowers considering a split loan must understand how the structure works and make sure it is affordable, even if tax benefits are denied down the track.
In addition, she advises checking out interest rates and penalties for those considering switching.
Split loan interest rates are lower than the average standard variable home loan rate of 6.57 per cent.
But Montgomery says some mortgage providers do offer lower rates - Resimortgage, for instance, has a 5.75 per cent standard home loan rate.
Paul Sarkis, technical director at MLC, says split loans have the potential to change standard investment advice, which is often to pay off the home loan before buying investment assets.
"Split loans may not change products but may make it more attractive to borrow to invest," Sarkis says.
He says many lenders already allow borrowers to capitalise interest, particularly with line of credit products.
"Where you are borrowing against your home and it's increasing in value, normally lenders are happy to let you capitalise the interest as long as you have the security and the capacity to pay off the loan," Sarkis says.
