Debt recycling has gained traction in recent years and is a popular way to turn interest expenses from being classed as non-tax deductible to deductible.
The aim of the strategy is to gear an investment, maximise returns that are greater than the interest cost, maximise tax deductions and pay off non-deductible loans sooner. As with all strategies the devil is in the detail. There are some pitfalls that should be avoided to ensure this strategy is successful and doesn’t cause any headaches in the future.
The premise of debt recycling is the basis that interest deductibility depends on the purpose of the loan. Security of the loan is not considered. To exaggerate, if a low-value investment property was purchased using a personal loan (yes, this was possible many years ago). Then the interest would be tax deductible. The property would be mortgage-free. Yet the purpose of the personal loan cements the deductible eligibility. This is the bedrock of a debt recycling strategy. While this is an extreme example it is useful to understand the tax basis.
Debt recycling extends this concept to an existing loan. The aim is to reset the original purpose to a tax-deductible purpose. For example, if a mortgage was originally used to purchase an owner-occupied home with a current limit of $500K, a balance of $300K and a redraw of $200K. The $200K in redraw could then be drawn out to purchase shares (or any other investment purpose). Interest from this $200K loan would then be tax deductible. If extra repayments to the $300K non-deductible portion are made in the future (building up redraw). By applying the same process again and purchasing additional investments this would increase the balance of the tax-deductible loan portion. Over time, this slowly changes the loan to being tax deductible. One crucial aspect of this process is to maintain accurate record-keeping showing the change in loan purpose.
Loan Splits
Loan splits are a great way to maintain accurate record-keeping and easily identify claimable interest. In the above example, when the redraw is drawn out it would be wise to split the loan into portions. This allows separate statements to be issued which can be used to both identify claimable interest easily and more importantly show the loan’s purpose being reset.
Without loan splits calculating the claimable interest is an extremely difficult task – especially if funds are also redrawn later for personal purposes. Without loan splits it also eliminates the ability to focus on paying down the non-deductible portion first. With all debt in the one account, all repayments are applied equally. In comparison, separate splits allow additional repayments to be made to one split solely (i.e. the non-deductible portion).
Loan splits also allow different repayment types for each portion. Commonly interest only repayments will be set against the investment splits (maximising tax deductions). Principal and Interest set to the non-deductible split. Any extra repayments or windfalls (i.e. tax refunds, dividends, etc) are then credited to the non-deductible split. Splits provide a variety of benefits with this strategy but are not to be confused with an offset account.
Redraw vs Offset in a Debt Recycle Strategy
Redraw is different to an offset account. In the above example, if those extra repayments were held in an offset account. Then simply debiting the offset account to purchase the shares would not make the loan tax deductible. The loan and offset are separate accounts. In this instance, the loan has had no change (no balance reduction and a later increase to purchase the shares). The shares have simply been purchased using cash and no interest would be tax deductible.
If funds are held in an offset, then it requires an additional step to make the interest deductible. The offset funds need to be transferred to the loan (side note – it is important to leave a small loan balance to avoid automatic closure by the lender). Create a loan split at the same amount as the investment. From the newly created loan split, draw the funds back out (after 1 day is advisable) and purchase the investments. Again, it is important to keep account statements to show the loan being reset (i.e. loan paid out and drawn back up – the reset).
Debt recycling is a great way to assist in eliminating your non-deductible debt sooner. It can be utilised often with extra repayments or as a once-off event (i.e. windfall or inheritance) to funnel funds via a non-deductible loan and reset its purpose. As always speak with your advisor if this is right for you and the steps involved to make it a successful strategy.
Further Reading
https://www.ato.gov.au/tax-and-super-professionals/for-tax-professionals/prepare-and-lodge/tax-time/tax-time-toolkits/tax-time-toolkit-for-investors#ato-Rentalpropertiesborrowingexpenses
Simon Podger & Bodie Simpson
Director of Lending & Director of Accounting, Your Future Strategy
The views expressed in this article are opinions only and do not constitute personal financial advice.
Debt recycling has gained traction in recent years and is a popular way to turn interest expenses from being classed as non-tax deductible to deductible.
The aim of the strategy is to gear an investment, maximise returns that are greater than the interest cost, maximise tax deductions and pay off non-deductible loans sooner. As with all strategies the devil is in the detail. There are some pitfalls that should be avoided to ensure this strategy is successful and doesn’t cause any headaches in the future.
The premise of debt recycling is the basis that interest deductibility depends on the purpose of the loan. Security of the loan is not considered. To exaggerate, if a low-value investment property was purchased using a personal loan (yes, this was possible many years ago). Then the interest would be tax deductible. The property would be mortgage-free. Yet the purpose of the personal loan cements the deductible eligibility. This is the bedrock of a debt recycling strategy. While this is an extreme example it is useful to understand the tax basis.
Debt recycling extends this concept to an existing loan. The aim is to reset the original purpose to a tax-deductible purpose. For example, if a mortgage was originally used to purchase an owner-occupied home with a current limit of $500K, a balance of $300K and a redraw of $200K. The $200K in redraw could then be drawn out to purchase shares (or any other investment purpose). Interest from this $200K loan would then be tax deductible. If extra repayments to the $300K non-deductible portion are made in the future (building up redraw). By applying the same process again and purchasing additional investments this would increase the balance of the tax-deductible loan portion. Over time, this slowly changes the loan to being tax deductible. One crucial aspect of this process is to maintain accurate record-keeping showing the change in loan purpose.
Loan Splits
Loan splits are a great way to maintain accurate record-keeping and easily identify claimable interest. In the above example, when the redraw is drawn out it would be wise to split the loan into portions. This allows separate statements to be issued which can be used to both identify claimable interest easily and more importantly show the loan’s purpose being reset.
Without loan splits calculating the claimable interest is an extremely difficult task – especially if funds are also redrawn later for personal purposes. Without loan splits it also eliminates the ability to focus on paying down the non-deductible portion first. With all debt in the one account, all repayments are applied equally. In comparison, separate splits allow additional repayments to be made to one split solely (i.e. the non-deductible portion).
Loan splits also allow different repayment types for each portion. Commonly interest only repayments will be set against the investment splits (maximising tax deductions). Principal and Interest set to the non-deductible split. Any extra repayments or windfalls (i.e. tax refunds, dividends, etc) are then credited to the non-deductible split. Splits provide a variety of benefits with this strategy but are not to be confused with an offset account.
Redraw vs Offset in a Debt Recycle Strategy
Redraw is different to an offset account. In the above example, if those extra repayments were held in an offset account. Then simply debiting the offset account to purchase the shares would not make the loan tax deductible. The loan and offset are separate accounts. In this instance, the loan has had no change (no balance reduction and a later increase to purchase the shares). The shares have simply been purchased using cash and no interest would be tax deductible.
If funds are held in an offset, then it requires an additional step to make the interest deductible. The offset funds need to be transferred to the loan (side note – it is important to leave a small loan balance to avoid automatic closure by the lender). Create a loan split at the same amount as the investment. From the newly created loan split, draw the funds back out (after 1 day is advisable) and purchase the investments. Again, it is important to keep account statements to show the loan being reset (i.e. loan paid out and drawn back up – the reset).
Debt recycling is a great way to assist in eliminating your non-deductible debt sooner. It can be utilised often with extra repayments or as a once-off event (i.e. windfall or inheritance) to funnel funds via a non-deductible loan and reset its purpose. As always speak with your advisor if this is right for you and the steps involved to make it a successful strategy.
Further Reading
https://www.ato.gov.au/tax-and-super-professionals/for-tax-professionals/prepare-and-lodge/tax-time/tax-time-toolkits/tax-time-toolkit-for-investors#ato-Rentalpropertiesborrowingexpenses
Simon Podger & Bodie Simpson
Director of Lending & Director of Accounting, Your Future Strategy
The views expressed in this article are opinions only and do not constitute personal financial advice.