Most of us buy an investment property because it offers us the ability to obtain a tax deduction for the ongoing interest expense on the money that we borrow when we purchase the property. Our expectations are that the value of the property will increase over time and that we will make a nice capital gain and receive higher rents in the future – sound thinking. The fact that we get a tax deduction against our income tax now at tax rates of up to 45% (depending on individual tax rates) for the interest expense and that we potentially only pay tax on 50% of any capital gains we make from the property when we sell it in the future, makes this investment strategy attractive from a taxation perspective.
The rules around whether the interest on a loan is tax deductible
Without going into all of the detail 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 (CGT) 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 Purpose Test
There is a common misconception that the property which is being used as security for the investment loan is the important issue, but in most cases this is almost totally irrelevant. When determining whether the interest on a loan is tax deductible its critical to know what is the purpose of the loan, as this will determine whether the interest is tax deductible. For example, you can borrow against your principle place of residence 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. Of course you will need to keep accurate records of how loan funds are disbursed so you can show these to the tax office in the case of an audit. You should also consider these implications at times when you are re-financing loans to ensure that a tax deductible loan purpose is not accidently changed.
The Offset Account
Now that we have a basic understating of why we get a tax deduction on an investment property loan let consider why every property investor should have an Offset Account. The Offset Account helps to ensure we do not accidentally alter the loan purpose as well as helping us keep clear and separate records. This is best illustrated by an example below.
Bob buys an investment property for $500,000 and borrows the money by offering a mortgage over his owner occupied home worth $750,000.The interest on this loan is still tax deductible even though the investment property is not mortgaged, because the purpose of the loan was to buy an asset that will produce assessable income.
Sometime later, Bob sells his business for $200,000 and elects to reduce his original loan down to $300,000 in order to save interest. He is now ahead on his mortgage and can re-draw funds as he likes.
Eight months later Bob does some renovations on his owner occupied home and re-draws $200,000 from the loan, the original purpose of the $200,000 component of the loan has now changed. Bob now has a $300,000 tax deductible loan and a $200,000 loan which is not tax deductible. Bob has unintentionally diluted his $500,000 tax deductible debt and in the process created a bit of an accounting nightmare. When he makes future repayments against the loan, there is no clear way to determine whether he is reducing the original tax deductible loan or the non-taxable loan. Bob will claim that he wants to repay the loan on which he does not get a tax deduction, but the tax office may determine otherwise. (See TR 2000/2)
Bob could have avoided all of these problems if he had an Offset Account attached to his investment loan. An Offset account is a totally separate account which is linked to the loan account and reduces the gross amount of the loan account to give a net balance each month, which the bank then uses to calculate interest. The Offset account acts like a savings account where Bob could have “parked” the $200,000 for as long as he wanted to without reducing or altering the original purpose when he repaid the $200,000. He would still have saved exactly the same amount of interest on the loan but at the same time preserved the maximum tax deductibility into the future.
Bob’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. Mortgageport understands that everybody is different and it’s not just interest rates that are important, loan structure, advice and service is always is better value when also combined with competitive interest rates.