Be careful with how you structure your debt, lest you lose your interest deductions
It is not uncommon for people who are upgrading their home to keep it as a rental property as they buy a new one. After all, this presents a good opportunity to start investing in property.
Take young professional, Claire, as an example, who bought her first inner-city apartment for lifestyle reasons.
Being an avid saver, she has always paid twice the minimum weekly repayment on her mortgage, which has significantly accelerated the level of equity she has in the property.
Claire recently met someone and as things were looking pretty serious, they decided to move in together.
The trouble was – Claire’s apartment was too small for two people, so she decided to buy a new place for her and partner.
However, Claire thought holding onto the first property and turning it into a rental property may be a good way to start her property investment journey.
Claire understood the concept of negative gearing, which basically meant that any net loss she made on the rental property could be used to offset her wages and other income.
Therefore, she realised that she needed to maximise the loan on the rental property as the interest on this loan would be tax-deductible and minimise the loan on her new home as the interest on this loan would will not be tax-deductible.
To achieve this, Claire went off to the bank and redrew all the extra repayments she made on her first home.
She then took out a new loan, together with the redrawn amount, to fund the purchase of the new property.
She figured now that the loan on her first property had gone back up by the redrawn amount, she was maximising her tax-deductible interest as this loan related to the purchase of her first property.
Little did she know that what she did would not actually achieve what she intended.
Conceptually, Claire has got it right. We all know there is ‘good debt’ and ‘bad debt’.
The good ones are those that give rise to tax-deductible interest.
What Claire did not realise was that the Australian tax law very literally looks at how loan funds are actually applied to determine if the interest incurred on those funds is related to an income-producing purpose and gives rise to tax-deductible interest.
Where it all went wrong for Claire was when she redrew her additional repayments from the first loan, those funds were being applied to buy a non-income-producing asset.
Therefore, the interest on the redrawn funds would not be tax-deductible, even though they came from a loan that was originally drawn down to buy her old home, which had become income-producing.
Obviously, this outcome would significantly erode the negative gearing tax benefits Claire thought she was going to get.
Perhaps if Claire has consulted her tax adviser, the adviser would have proposed a different way to safeguard the tax deduction on the re-drawable repayments on her first loan.
For instance, if Claire had sold her first home to her partner, who was also earning income at a level where negative gearing would be of benefit, her partner could have drawn down a tax-deductible loan to buy Claire’s first property, effectively releasing the additional repayments for Claire to buy the new home and pay off the balance of her first loan.
As the first home was Claire’s main residence, there would not be any capital gains tax on the sale. However, Claire’s partner would be liable to pay stamp duty on the purchase. Therefore, a cost benefit analysis would need to be done to ensure that the strategy would be worthwhile.
In the end, there are many ways to skin a cat and there is no one size fits all solution, so it may be worthwhile to speak to your trusted adviser before you make any big financial decisions.
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