Halve the cost of your interest bill through smart debt structuring
Prosperity Advisers Group
How you spend borrowed money determines the tax deductibility of your debt. Where you use borrowed funds for business or income producing purposes it is called “deductible debt” and you get a tax deduction for any interest paid. Where you use borrowed funds for personal purposes eg your home or holidays this is “non-deductible debt” and you do not get a tax deduction for the interest. Depending on your marginal income tax rate, the difference between debt being deductible rather than non-deductible can effectively halve the cost of your interest payments.
Here are some strategies we recommend you consider to maximise and preserve your debt deductibility:
1. Ensure appropriate structuring upfront each time you
Keep separate loans for each borrowing. Once you combine loans you can never separate them again. So if you consolidate borrowings for say 3 investment properties, a percentage of the interest on that consolidated borrowing relates to deductibility for each property interest. Once consolidated, you can then never split these again. If you sell one property, or choose for it to be used for private purposes, this creates problems with managing and maximising the deductibility of interest. Subject to bank costs of doing so, separate loans is always best for tax.
2. Recycle non-deductible debt to create deductible debt
Do you have a family trust or company that owes you money via a loan or beneficiary account that it doesn’t have the funds to pay you, and separately you have a non-deductible home loan? Companies and trusts can borrow to repay shareholder and beneficiary entitlements. These borrowings are tax deductible. Have your company or trust borrow money to repay you and get a tax deduction for the interest. Use the funds received to reduce your home loan. Your overall debt position hasn’t changed but you have swapped non-deductible debt for deductible debt.
3. Use offset accounts rather than redraw
Using redraw and offset accounts has become a popular way to use your savings to reduce interest costs but be able to access the funds when needed. Funds in an offset account are never considered to reduce the primary loan balance, it is just a bank account structure where the interest in the savings “offset” reduce the interest calculation on your loan. As compared to this, using a redraw facility you actually pay additional amounts off your loan and then “redraw” or increase the loan again when you wish to access the funds. From a tax viewpoint under an offset facility the primary loan retains its tax status and value regardless of the use of funds in the offset account. The redraw however sees you repaying the original loan and you need to consider the purpose of the redrawn funds and consider a prorata of the interest against the multiple loan purposes. Take for example an investment property loan which is tax deductible and you use available funds on this loan for an extension on your home (non-deductible). Using an offset account this loan remains fully deductible against the investment property but under a redraw the loan now has mixed purposes for the deductible investment property balance as well as a nondeductible component for the home extension.
We live in a society where high debt levels are common. Ensuring you structure your debt tax effectively can greatly impact your after-tax disposable income.