Paying interest in Advance

(last updated 23/04/2014) 

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As the end of the financial year approaches, many investors become focused on tax planning. One popular option is paying interest in advance, for example, paying one year’s interest as a lump sum in June. 


Making the payment in advance effectively changes the timing of a tax deduction, bringing it forward one year. The advantage is that an investor can claim a deduction for the expense in the current financial year. So, on top of this year’s refund they’ll also get some of next year’s refund a year early (see following case study).
Example:
Danny has an investment property which will generate him $20000 income in 2009. He has a $300,000 loan in place used to purchase his investment property. The loan has interest payable at 6% per annum. 

Danny has been making interest payments steadily through 2008-09 on this loan and has now been made aware of the ability to prepay his interest expense for the next 12 months. Danny also earns $80,000 salary income every year.

The table below shows the savings Danny can generate by prepaying his interest liability for the 2009-10 income year before 30 June 2009.

No
Prepayment

With
prepayment
Salary income
$80,000

$80,000
Investment Income
$20,000

$20,000
Assessable income
$100,000

$100,000
Interest deduction – 2008-09
$18,000

$18,000
Prepaid interest for 2009-10


$18,000
Taxable income
$102,000

$84,000
Tax payable
$26,800

$19,370





By implementing the pre-payment strategy, Danny has brought forward a tax saving of $7430.
There is an obvious advantage to paying interest in advance. However, there are some Tax Office rules and guidelines that must be followed in order to maintain compliance.

The ATO has a twelve month rule that determines tax detectability. The rule applies to both small businesses and to property investors. Prepaid expenses are deductible in the year incurred, provided the expense relates to a period of twelve months or less. Further, the period it relates to must end no later than the last day of the following financial year. So, for interest paid in advance to be deductible, the amount must be calculated strictly within a twelve month period. If it is calculated for a period over twelve months, the deduction must be apportioned over the term of it relates to.

Most financial institutions offer “interest in advance” loans. By there nature they are fixed rate loans so the amount of interest can be accurately determined. These loans most benefit experienced investors with a well researched and long-term strategy. Healthy cash flow or good savings habits are needed in order to pay the fixed amount of interest at the same time each year. A final note, investors wanting to utilise interest in advance should check with their financial institution whether that feature is available in their existing loan.

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