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Paying interest in advance


Sunday 01 April 2018

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 benefit from 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.

Example

Ian currently has a $100,000 loan with a variable rate and is making regular monthly repayments. By switching his mortgage to a fixed rate, his lender allows him to lock his interest rate in at 5.4 per cent per annum if prepaying interest annually in advance ($5,400). By comparison, if Ian does not want to prepay his interest annually in advance, the lender offers a fixed rate of 5.5 per cent per annum, allowing Ian to pay interest of $5,500 in 12 monthly instalments over the same period.


Tax deductibility

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 interest is deductible non-business expenditure
  • no more than 12 months’ interest is being paid in advance
  • the 12 month period ends before the end of the following income year.

The investor is a small business entity and...

  • the interest is deductible expenditure
  • no more than 12 months’ interest is being paid in advance
  • the 12 month period ends before the end of the following income year.

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.

Example: Susan

Susan prepays $18,000 interest in advance (representing 12 months’ interest) on her investment loan on 30 June 2018. Susan meets the 12 month rule and may claim a immediate tax deduction for the prepaid interest of $18,000 for the 2017/18 income year.

Consider now the impact if Susan instead pays $19,500 interest in advance (representing 13 months’ of interest) on 30 June 2016, covering the period from 30 June 2018 to 31 July 2019 (a period of 397 days).

Susan will not meet the 12 month rule because the period of pre-payment exceeds 12 months and does not end until after the following income year. She will need to apportion her tax deduction (based on daily calculations) over the period the interest relates to.

The apportionment calculation is as follows:

ApportionmentDeductionYear deduction claimed
$19,500 x (1/397) = $49 2017/18
$19,500 x (365/397) = $17,928 2018/19
$19,500 x (31/397) = $1,523 2019/20


More information

Further information is available from the Australian Taxation Office. See Deductions for prepaid expenses 2017

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