The Reserve Bank of New Zealand uses the Official Cash Rate (OCR) to maintain price stability, i.e. to keep inflation between 1% and 3% over the medium term. Given the recent drop in the OCR (from 3.5% to 3.25%) and the potential for future reductions, it is timely to consider the benefits of changing the terms of your fixed term debt. For example, Bob fixed the mortgage on his rental property at 6.25% for three years. One year later, Bob’s bank is offering a 4.95% two year fixed interest rate. Bob is eager to change his mortgage to the lower rate, so he sets up a meeting with his bank manager. At the meeting Bob is told that he can change interest rates but will be charged a $10,000 Break Fee. Why is Bob charged this fee?
A break fee is generally charged as compensation for the loss the bank will suffer if the interest derived from an existing loan reduces as a result of a switch to a lower rate. It is generally calculated on the difference in the bank’s margin on the interest rates the borrower is moving between. For example, Bob borrowed $550,000 on a five year fixed term at 6.75% p.a. After three years Bob has $500,000 remaining on his home loan balance and wants to change interest rates to the better 4.95% on offer. Changing over to this interest rate would result in Bob’s bank losing about $18,000 of interest income. As a consequence, the bank may look to negotiate a fee of say $10,000 with Bob if he remains with the bank as an ongoing customer.
As break fees can be significant, it is also important for Bob to know whether it can be deducted for tax purposes.
Tax deductibility of break fees
In 2012 Inland Revenue issued three public binding rulings relating to the deductibility of break fees incurred by landlords:
- BR Pub 12/01 – break fee paid by a landlord to exit early from a fixed interest rate loan.
- BR Pub 12/02 – break fee paid by a landlord to vary the interest rate of an existing fixed interest rate loan (Bob’s situation).
- BR Pub 12/03 – break fee paid by a landlord to exit early from a fixed interest rate loan on sale of rental property.
Inland Revenue broadly concludes that break fees on borrowings are deductible where a landlord has borrowed to buy a property from which rental income is derived (or to refinance another loan for that purpose). However the timing of the tax deduction will depend on the situation in which the break fees are incurred.
If the break fee is incurred to repay the loan early, then the break fee will be deductible when it is incurred. In Bob’s situation, where the break fee is paid to vary the interest rate under the loan, it will depend on whether he is a cash basis person or not. Whether someone is a cash basis person is determined by the levels of debt and deposit arrangements to which they are a party. Cash basis Bob is able to deduct the amount of the break fee when it is incurred, unless he has chosen to adopt a spreading method, in which case it will be required to be spread over the term of the loan. Non-cash basis Bob will have to spread the fee over the term of the loan.
Whether or not to switch should be decided based on the cash flow cost to do so, the final negotiated fee with the Bank, whether interest rates are expected to increase or decrease and when the benefit of the tax deduction will be claimed.