Prepaying Interest Can Reduce Your Tax

interest-rates

Tips, Traps and a Case Study

Prepayments can be a very effective way to provide tax relief before 30th June each year. There are a number of specific rules around prepayments that are eligible to be a tax deduction when paid and others which are required to be written off over the period of the prepayment. We’re going to focus in this article on the prepayment of interest specifically which has been used by many clients to great effect over a number of years.

Remember, this advice is general in nature and does not cover all situations so you should book an appointment with one of our tax team to obtain specific advice before proceeding with this tax planning strategy.

What interest can be prepaid tax effectively?
A taxpayer who is a small business entity (businesses that turn over less than $2 million and meet the small business entity test) and individual taxpayers who have loans for income generating investments are generally entitled to a deduction for prepaid interest on those loans. The prepayment period is limited to 12 months so if a prepayment exceeds 12 months the benefit of this planning strategy is reduced.

Why prepay interest?
If you hold an investment that you plan to retain for the period of the prepayment (let’s assume that’s 12 months for this article) then interest is a cost that you will incur in any case over the next year. So if you are in a position where you have enough cash flow to pay the interest for the next 12 months now why not do it and obtain a tax deduction in the current year – it really is just bringing forward a future tax benefit.

But it’s far more than that – this strategy is particularly effective when you have abnormally income in a particular year that is higher than your regular taxable income. This could come from any number of situations. Some of the most common situations are:

• Capital Gain from the sale of a property
• Capital Gain from the sale of a parcel of shares
• An inheritance that has a taxable element
• A one off bonus payment for performance
• An Employment Termination Payment with taxable components
• A large Trust Distribution or Dividend received

In these types of situations prepaying the interest on an investment loan can both defer and reduce the tax payable as shown in the case study below. Remember, this applies to any investment and in the coming tax planning tips we’ll be showing you a specific technique that works if you don’t currently have a loan in place.

How does it impact my tax?
Quite simply, if you are eligible for this deduction then the tax benefit is brought forward by twelve months (or even longer if you take advantage of the various lodgment dates). Further to this, by applying this strategy to a abnormal high income year it actually reduces your tax liability over the two year period.

For a company with appropriate cash flow this strategy can be particularly effective in the 2014/15 Financial Year. The recent budget announcement provides an opportunity to prepay interest in the 2014/15 Financial Year and receive a tax benefit of 30%, rather than the benefit being only 28.50% as per the Budget announcement.

What are the pitfalls to be aware of?
With any strategy there are always areas of concern to consider before proceeding. Whilst every situation is different, generally these are the four primary issues that you should cover off before proceeding with this strategy.
• The benefit is primarily one of deferring tax, noting however the potential benefit of timing with a high income year. At some time in the future, if there is a year that you do not prepay the interest on the loan you will not be able to obtain a deduction for interest payments in that year.
• If you sell the underlying asset within the prepayment period the interest paid may not be recoverable. So if sale of the asset is being considered caution should be taken with this strategy.
• In order to prepay interest the lender may provide certain covenants – often there is no adverse consequences from these covenants however you should be clear on these before proceeding.
• Cash flow is always the king – like any interest payment the tax benefit is applied at your tax rate so there is a net outgoing. Before proceeding you should ensure there is sufficient cash flow to cover the outgoing interest payment without causing any financial distress.

What are the next steps?
If this is a strategy that you would like to consider for your current year tax planning there are a couple of key steps to take before taking up this option:
1. Consider this general advice and review the potential pitfalls so that you are comfortable that this option could work for you
2. Contact your lender and find out if they will make this option available for your current lending. If so, you will need to understand the lenders time line to make this happen prior to 30 June. If not, you should ask the lender what would be required to avail yourself of this prepayment option and make a decision whether or not you would like to proceed
3. Finally, arrange a tax planning session with one of the McMahon Osborne Group tax team to confirm that you meet the requirements to obtain a tax benefit and understand the quantum of the tax benefit.

Case Study
Evan is a truck driver with taxable income around $80,000 each year which increments slightly for CPI and occasional overtime work but generally is pretty stable. In September 2014 Evan sold an investment property that he has held for six years and calculated a gross capital gain of $120,000. With the proceeds he paid off his home loan. In March 2015 he purchased a new investment property for $400,000 and borrowed 100% of the costs using the investment property and his home as security. The interest rate on his new loan is 4.50%. The table below shows that by prepaying interest in the 2015 year, Evan reduces his 2015 tax liability by $7,020 deferring his tax payment and also providing an overall tax benefit as his income is unusually high in the 2015 year.

Interest table

Remember, this advice is general in nature and does not cover all situations so you should book an appointment with one of our tax team to obtain specific advice before proceeding with this tax planning strategy.

To participate in a tax planning session specific to
your needs and requirements please contact
Lynda on (03) 9744 7144 or email lynda@mcmahonosborne.com.au
to book a session with one of our tax specialists.
Our planning sessions come with a guarantee that if we can’t produce legal tax savings from our suite of options that exceeds 200% of your investment with us the session will be FREE so there is no financial risk to you for participation in these sessions.
Contact us today

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