The power of an Offset home loan for Investors
In my daily work, a misunderstanding I often come across amongst property investors is whether recycling debt against a property is “always” tax deductible. Property investors need to be across this issue as loan interest claims are a hot button for the ATO with regular audits being conducted.
There is a common misconception that the property which is being used as security determines the tax benefits relating to the debt secured against the property itself.
When determining whether the interest on a loan is tax deductible, it is critical to know what the purpose of the loan is, as this will determine whether the interest is tax deductible. For example, you can borrow against your Principle Place Of Residence (PPOR) and use these funds to purchase an investment property. The security for the loan is your home but the purpose should entitle you to a deduction on the interest on this loan.
On the contrary, if you have paid off debt against your investment property and you decide to borrow against the equity built up in the investment property, again it’s the purpose of the new borrowings that determines whether the loan interest is tax deductible and not the fact that the debt is secured against an investment property.
A borrower can claim a tax deduction for interest on an investment property loan because it’s an expense (allowable deduction) incurred in earning what is known as Assessable Income. This is defined in the Tax Act, but in relation to an investment property, the Assessable Income test is usually the rental income you receive or expect to receive from the property. It is important to know that Assessable Income does not include capital gains. This is dealt with under Capital Gains Tax rules and not the income tax rules, so you’ll need to keep this in mind and seek advice where necessary when deciding to buy an investment property.
The power of an Offset Account for Investors
An Offset Account is an excellent and a very powerful strategy which helps you to preserve future tax benefits relating to a property. This is best illustrated by an example below.
10 years ago Peter bought a PPOR home for $600k and borrowed $400k by offering a mortgage over his new home. Over the last 10 years Peter has been diligent with his money and managed to pay off a large portion of his home loan with a current outstanding balance of just $100k. That’s $300k Peter managed to pay off in the last 10 years.
Peter has now decided to upgrade his home and decides to retain his current PPOR as a long-term investment as he believes the prospects for ongoing capital growth are strong.
Peter approaches us and requests a refinance against his current PPOR (now worth $1million) and wants to gear at 80%, with a possible new loan against the property of $800k (i.e. $1million x 80% = $800k). Peter wants to use the equity release of $700k (i.e. new funds) towards a new home (PPOR) he plans to buy.
Like many people, Peter was under the impression that by re-borrowing against his current PPOR, the interest paid against the entire new debt of $800k can be claimed as a tax deduction once the property is tenanted. This is incorrect and it’s where a lot of people get it wrong.
The “purpose” of the additional new debt of $700k (i.e. $800k new loan less current loan balance of $100k) is to buy his new PPOR, therefore in this instance Peter can only claim the interest against the remaining debt of $100k, and not on the entire proposed new borrowings of $800k.
Could this situation have been avoided?
Peter could have avoided this situation simply by establishing an Offset home loan in the first instance, and setting the repayments on an Interest Only basis. Any principal repayments should then have been made into the Offset account, hence preserving the future tax benefits against the property.
Sometimes clients don’t plan to hold onto a property long-term and work very hard at paying off their home loan (which is great). However, if there is the slightest chance that the property may become a long-term investment for you, and you are likely to upgrade in the future, then an Offset home loan is the perfect structure for you. If you end up selling the property, then no harm done as you only pay interest on the net borrowings. Funds parked in Offset are offset against the home loan balance (daily) for the purpose of calculating interest.
Peter’s selection of the wrong type of mortgage and not seeking sound advice demonstrates how the lowest interest rate might not always be the best outcome for everyone. As mortgage professionals, this is something we advice clients on a daily basis as we want to ensure that your future tax benefits are preserved and flexibility is maintained at all times.
Disclaimer: If you intend to rely on any of the above information, you should request advice from a licensed tax advisor. This information does not take into account your individual objectives, financial situation and needs. You should assess whether the information is appropriate for you and seek specialist advice from a qualified taxation advisor.