27 Apr Paying interest in advance
As the end of the financial year approaches, investors may start to consider their investment and tax strategies. One strategy available is prepaying interest, known as interest in advance. Interest in advance is fixing the interest rate on an investment loan (often at a discount) for 12 months and paying the interest normally incurred throughout the year as one upfront interest payment.
Receiving a discounted interest rate, against standard interest rates, is not the only advantage of this strategy. Depending on individual circumstances, prepaying interest may provide other benefits.
Why prepay interest?
Investors may choose to pay interest in advance for a number of reasons including:
- cash flow and budgeting – utilise a lump sum available at certain times of year (for example a bonus), or simplify finances by making one prepayment of interest upfront
- locking in a fixed annual rate – protect against possible interest rate rises over the 12 month period and possibly enjoy a discounted fixed interest rate
- immediate tax deduction for prepaid interest – a tax deduction may be available in the year of payment (where certain criteria are met). The benefit of an immediate tax deduction may be even greater where assessable income is currently higher now than it is expected to be in future years if, for example, there is an expected break from the work-force.
Locking in a fixed rate
When paying interest annually in advance, a lower fixed interest rate will typically apply compared to fixed monthly payments throughout the year.
Prepaid interest may be tax deductible depending on individual circumstances. Generally, a tax deduction is allowed for interest on borrowings to the extent the interest is.
- incurred in gaining or producing assessable income, or
- necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.
The interest expense will not be deductible where it is:
- private or domestic in nature (e.g. borrowing expenses used to purchase a private home)
- capital in nature, or
- relates to producing exempt or non-assessable non-exempt income.
Immediate tax deduction
Generally a deduction for prepaid interest should be apportioned over the period the interest expense relates to, resulting in some of the prepaid interest being deductible only in future income years. However, by meeting the requirements of certain prepayment rules, it may be possible to claim an immediate tax deduction for up to 12 months of prepaid interest.
|12 month rule
An immediate tax deduction can be claimed for the entire amount of the prepaid interest under the ’12 month rule’ if:
The investor is an individual and…
The investor is a small business entity and…
Immediate tax deduction for prepaid interest does not apply to certain tax shelter arrangements. A typical negative gearing arrangement involving real property, listed shares or units in widely held trusts is not considered to be a tax shelter arrangement for this purpose, so prepaid interest may be immediately deductible.
Information above is general and to ensure that interest in advance is suitable for your personal situation you should seek advice from your accountant or tax specialist. Furrther information is also available from the Australian Taxation Office website, http://www.ato.gov.au