Tax Tip 2: Debt Recycling

Tax Tip: Debt Recycling

'Retirement’ can arrive sooner if you can pay off non deductible debt faster. Interest on a loan used to purchase the main residence is not deductible - some call this bad debt. While interest on loans used to purchase investment properties (shares, business etc too) is deductible.


So wouldn’t it be good if you could change bad debt into good debt?


Well, you can!!


As an example, most people would be paying PI on their home loan. The balance would be slowly decreasing. Some are paying extra paying it down faster. If you could reborrow this money paying off the loan and then invest it you would be charged around 4.5% pa in interest. This interest would then be deductible against the income from the investment. If the investment earns more than 4.5% pa then you would be in front and the extra money received could then be used to pay down the bad debt even faster.


Further reduction in bad debt would potentially mean more funds are available to be borrowed to invest. This in turn would potentially lead to more income to pay off the bad debt which could then be turned into good debt by borrowing again to invest.


If all goes well this could enable the bad debt to be paid off much quicker.


This could be done with property, but most property would end up negative cash flow. But it could also be done with this and just hanging on for a few years and then selling and using the proceeds to pay down the bad debt and then reborrowing.


Or you could speak to a licenced financial planner about using shares to do this. Shares are much easier to buy and the costs in and out are very low. But they can also be very volatile and potentially dangerous. But there are relatively safe ways to do this..


Carefully planned, debt recycling can get you where you want to go sooner.

 

Terry, what about directing rents to the PPOR loan thus reducing its debt and letting the Investment debt capitalise to the same rental amount directed to the PPOR ?

 

Rixter - that deserves a whole new thread!

 

Yes, it can be a very effective way to debt recycle.

 

I am not sure of that. Could you give me an example of what you mean?

 

Nice one terry
1.Could u also do this for seminar expenses, board regulaton fees, professional indemnity fees, income protection, life insurance, car insurance etc etc ... related to your career that u r freating income

2.Is there any time limit on deducting these expenses. Eg 30yrs

3.For property,eg buyers agent fees,depreciation schedules, travel allowance to inspect ips, body corporate fees, rates,water etc. Any time limit on these apart from when u sell the ip

4. Is loc easier to do this compared to redraw
Never used redraw b4 but can u do direct etf from redraw without transferring to another acct

Obviously provided u m can pay ppor by the same amount your loan is increasing
Thanks

 

Here is what I do.

(The percentages are obviously arbitrary)

 

Hi Spludgey,

Looks great and thanks for the diagram.

Do you pay interest on IPs from the LoC as well?

Do you claim the interest on the LoC (i.e. Interest on IP interest) at tax time?

 

Yes and yes.
In practice, it's a loan with an offset and I use the offset account for the interest payments, but the principle is the same.

 

Terry/Rick, are you able to elaborate on this a little bit.

How about this example scenario.

PPoR Balance - $500,000

IP#1
Interest - $12,000 per year
Expenses - $4000 per year
Rental Income - $12,000 per year

LoC#1
Funds available - $50,000

Can I have the rental income sit in my offset account and pay the expenses for the IP from the LoC? So, at the end of the tax year, situation will be...

PPoR Balance - $488,000 ($500k - $12k rental income)
LoC: Funds available - $34,000 ($50k - $16k IP expenses)
Interest paid on LoC - $800

Can I then claim the $800 as a deduction?

Please correct me if my understanding is wrong and thanks in advance.

 

Paying interest from the LOC is where a lot of people get into trouble with debt recycling. There's instances where private tax rulings have been obtained to allow it, but I've seen people get into ATO trouble trying this.

Better to have all your income go into an offset account (against your non deductible debt) and have your loan repayments come out of that same offset account. The LOC is used to fund other costs, interest on the LOC is also paid by the offset account.

 

Hope you have sought tax advice

 

Probably not. You are borrowing to pay interest.

This is a different 'thing' than I was talking about above.

 

I have. I talked to an accountant who said that this is a bit of a grey area and that the auditor general could rule against it, but that it was okay to claim unless I was told otherwise by the ATO.

 

Thanks Peter and Terry. That's what I thought. Good to know that non-interest expenses can be paid from the LoC though and we can legitimately claim the interest on those as deductions. That adds up to about $20k sitting in offset for me rather than paying cash for these expenses.

Good on you spludgey for getting it clarified for your situation.

 

I disagree with this.

What is your purpose in borrowing to pay interest?

 

I have had this suggested as a "strategy" to pay-off your PPoR debt faster by a BA a few years ago. But it sounded dodgy to me.

 

ATO have clearly stated that they will apply Part IVA to deny deductions in this case. Not a grey area

 

I can only tell you what I've been told by the accountant, but thank you for pointing out that it might not be a valid deduction. I'll look into it further and might ask another accountant.

 

TD 2011/D8

Income tax: does a taxpayer's purpose of 'paying their home loan off sooner' mean that Part IVA of the Income Tax Assessment Act 1936 cannot apply to an 'investment loan interest payment arrangement' of the type described in this Taxation Determination?
http://law.ato.gov.au/atolaw/view.htm?docid="DXT/TD2011D8/NAT/ATO/00001"