How a tax subsidy works on investment loans

Borrowing for investment is a tax effective way to build wealth.

We have a tax system that is biased against saving because the tax office takes up to 47 per cent of the interest you earn.

On the other hand, if you take out a loan to buy property or shares, the tax office subsidises up to 47 per cent of the interest; yet provided you keep the asset for at least a year, you pay capital gains tax at a maximum rate of 23.5 per cent.

On the face of it, the tax treatment is simple. Provided the purpose of the loan is to buy income-producing assets, the interest will be tax-deductible.

A common question I get is: “suppose I upgrade from my existing home to another home, and rent out the original one, can I take a loan against the original home for the mortgage on the new one and claim the interest as a tax deduction?”

The answer is an unequivocal no, because the “purpose” of the loan is for private use – to buy a new home to live in – and that has nothing to do with the property being used as security for the loan.

However, a loan can change character. The interest on your home loan will not be tax-deductible while you are living in it, but if you vacate the property and rent it out, you can then claim interest and other outgoings as a tax deduction and at the same time will have to declare the rental income as taxable income.

The cream on the cake is that you can then be absent from that home for up to six years without losing the capital gains tax exemption – provided you don’t claim any other property as your principal residence in that time.

There is confusion about home loan accounts with a line of credit or redraw facility, and offset accounts. It’s worth taking the time to understand them because they are vastly different animals and getting it wrong can be very costly.

An offset account is simply a savings account in which the interest is deducted from your loan interest instead of being paid to you as taxable income.

At any stage, funds can be withdrawn from the offset account without tax implications. In contrast, every time you make a withdrawal from a redraw facility or line of credit account, you are establishing a new loan.

Suppose a couple have a $400,000 loan on their home and have the goal of eventually upgrading to another home and renting the original out.

Over the years they have accumulated $350,000 in their offset account, which means they effectively owe only $50,000 on their property. When they make the move they simply withdraw the $350,000 from the offset account and use that as a deposit on the new home. This leaves them with a $400,000 debt on the original property – now tenanted – and they can claim all the interest on it as a tax deduction.

Their neighbours also once had a $400,000 loan but have worked hard to reduce the debt to $50,000. If they move out, their debt on the now-rented property will be stuck at $50,000.

Certainly, they could redraw funds from the original loan to buy their dream home, but the interest will not be tax-deductible. They will have a huge non-deductible debt on their new residence, as well as paying tax on the rents from the original property.

An investment line of credit loan can be a particular trap if borrowers do not keep their business and private expenses strictly separate. Unfortunately, far too many borrowers deposit their salary into the investment loan account and then withdraw funds each month for normal living expenses.

They do not realise that the deposit of the salary is treated by the tax office as a permanent reduction of the debt, and each redraw as a new loan. Because the redraws are used for a private purpose such as paying for groceries, the loan very quickly loses its tax-deductibility.

The lesson in all this is that you should keep your investment and private borrowings separate and always use an offset account if you intend one day to rent out a property that is presently used as your own residence.

– REALESTATEVIEW.COM.AU