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When it comes to managing property loans or investment debt, many Australians explore different strategies to improve cash flow and reduce tax liability. One such strategy is capitalising interest—but it’s essential to understand how this works and when it’s acceptable from a tax perspective.

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What Is Capitalised Interest?

Capitalising interest means not paying interest when it falls due, and instead allowing it to be added to the loan balance. Over time, you end up paying interest on the interest—this is often referred to as compound interest.

The Australian Taxation Office (ATO) defines compound interest as:

“Interest that accrues on interest that is unpaid.” — TD 2008/27, para 7

The good news is that if the original loan is for income-producing purposes—like a rental property or business—the capitalised interest may also be tax-deductible, just like regular interest. This principle has been confirmed by the courts and the ATO in several rulings.

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Why Might Investors Consider Capitalising Interest?

From a tax planning perspective, capitalising interest can seem appealing. For instance:

• You could borrow to pay the interest on an investment loan.
• This frees up your cash flow, which could then be used to pay down your non-deductible home loan.
• It may also increase your deductions in the short term, reducing your taxable income.

However, this strategy must be approached with caution.

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When Capitalising Interest Can Be Risky

The ATO has strong anti-avoidance rules under Part IVA of the Tax Act, which allow them to deny deductions where the dominant purpose of a strategy is to gain a tax benefit.

In TD 2012/1, the ATO made it clear: if your primary reason for capitalising interest is to create extra tax deductions—particularly with the intention of accelerating repayments on your home loan—they may deny the deduction.

The ATO has even stated that "paying off the home loan sooner" is not considered a sufficient reason to justify the arrangement.

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Legitimate Scenarios Where Capitalising May Be Acceptable

Not all situations are tax-avoidance schemes. The ATO acknowledges that compound interest may still be deductible under ordinary tax provisions, especially when the decision is driven by genuine financial need, such as:

• Loss of employment
• Maternity or paternity leave
• Illness or injury
• Unexpected financial obligations
• Retirement and reduced income

In these scenarios, the dominant purpose is not to create a tax benefit, but to manage cash flow. This distinction is crucial.

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Final Thoughts: Capitalising Interest Requires Expert Guidance

Capitalising interest can be a helpful tool to manage cash flow during challenging times or when juggling multiple financial priorities—but it must be used correctly. While the ATO allows deductions in some cases, using this strategy with the dominant purpose of reducing tax can lead to deductions being denied under anti-avoidance rules.

The key is to ensure that your purpose is legitimate—such as cash flow constraints—and that you maintain proper documentation. If you're considering capitalising interest, seek tailored advice before taking action.

Need help navigating loan strategies and ensuring ATO compliance?

At Plan Tax, we specialise in helping small business owners and investors make smart, tax-effective decisions—without triggering red flags with the ATO.

Book your tax planning consultation today and get personalised advice that works for your situation.