Tax Tip 2: Debt Recycling

Thanks @Terry_w, I think I'll tap into equity for one more next year and save hard. Saving 1400 a week currently, that will change once I move out and rent, I don't want to buy for 3 years or so though. I have two places in picton ATM, and I'll be living in Camden eventually

 

Terry, I'm in a situation with a child on the way. Cashflow will be tight, we're going from two to one incomes and a LOC will be used to pay investment expenses for the next year or two (currently $o owing with a $30k limit). I have some higher interest non-deductible debt (personal loan) that is more of a burden on cashflow than the LOC.

Given the ability to pay the interest on our investment loans (only home loans we have) from the LOC, I'd take it and direct the savings to higher interest debt that has a higher cashflow burden until it's paid off.

The interest on that interest should be deductible in this situation, as far as I can tell. There's no scheme to reduce tax, just trying to survive on lower income.

 

Vixs that may be possible. Get some tax advice to confirm.

Have you thought about using the LOC to pay off that personal loan in one hit - refinancing it? Consider whether you need to split the loan first of course.

 

I am about to refinance my PPOR, so should be in a position to do an equity release and setup some IO loan splits for investment.

This is what I am thinking of doing based on my current limited understanding of debt-recycling:

IO Split 1: Expenses for IP #1
IO Split 2: Purchase costs / deposit / expenses for a future IP #2
IO Split 3: Purchase shares / ETFs

( depending on lender, each split may have it's own offset )

My PPOR will be refinanced at variable P+I with an offset account ( my current offset balance is quite healthy ).

At the moment I am using a separate transaction account/buffer for IP #1 expenses. Rent payments from my PM currently go into this account. The only expenses I have out of this account currently are rates since other expenses are payed by my PM. Currently my loan repayments for IP #1 come out of this account.

My understanding of how to use the debt-recycling approach is:
1. Pay my salary, share dividend and rental income into my PPOR offset
2. Expenses relating to any IP are paid from the respective loan split
3. Interest and P+I payments on all my loans are paid from my PPOR offset

Is the above approach correct/optimal?

In practice, can I setup all the loan repayments for my various loans as direct debits from my offset? ( I want the loan repayments to be set and forget )

Principal balances on the IO splits will trickle up over time. Current thought is for interest payments to be paid automatically by direct debit and for the principal balance of the various investment IO splits to be periodically paid down to a healthy level ( qtrly, 6-monthly or annually - not sure what interval works best for balancing debt-recycling purposes versus overall portfolio / LVR risk ).

For share purchases, I understand I just need to setup a CommSec account and then nominate the relevant IO Loan Split as the account to use for share settlements. Does CommSec allow this, even if the loan is with a different bank? Plan is to top up my share portfolio quarterly or when a good buying opportunity presents itself. Does CommSec allow dividends to be directed to a different account to that used for share settlements?

To date, I've always nominated to receive dividends via dividend reinvestment where possible, however I was wondering if it is now better to receive all dividends as cash to my offset? My current portfolio is with Suncorp Sharetrade.

Any comments on the above?

I still need to chat to my accountant / fin. planner but want a better understanding of the technicalities of how to run it first. My MB is getting fed up with questions! The benefit of this discussion will likely be how debt-recycling improves my equity and asset base ( taking into consideration actuals for my PPOR / IP / share portfolio value ).

 

@wombat777 I'll need to read that a few times to comprehend by then someone who knows what they're doing well come along
But one thing have you looked at IO for the ppor and you pay the p&i difference into the offset so you have the cash avail. Someone can confirm that too

 

Thats a good way to do things, but no need for separate offsets (unless you have more cash than the loan amount.

 

Thanks Bob, thought about that. I'm reluctant to do that as it may affect my serviceability calcs for my next IP. With my next IP it looks like I will hit my serviceability limit. Ironic since I have a fair amount of spare cash from my take-home pay each month. It's a pity banks don't use actuals for expenses.

 

Yep, as long as the dividends are large enough to make the exercise worthwile. Chances are the tax benefits of having the dividends paid out in cash to your offset and then buying more shares from a deductible loan will out-weigh the brokerage fees and any discount on the DRP.

 

I imagine that another factor here is that dividends received as cash are treated as income by the banks and would therefore help increase total income to improve serviceability. Does anyone know whether banks consider reinvested dividends as income???

 

Yes some banks do consider dividends as income - e.g. Westpac take them into account for example.

 

There is a debt recycling calculator here. Have not been able to try it yet.

Free Mortgage Debt Recycling Calculator Excel

 

Interesting calculator but very basic - just goes on total annual return for some investment - doesn't distinguish between dividends and capital gains on shares for instance.

BTW this is a great site full of useful spreadsheets. Investment Property Calculator Excel Spreadsheet

 

Does Debt Recycling Strategy only work if the PPOR is in P&I loan because you'd need to be paying off the principal, then you can ask the bank to lend you that amount that you've paid off the principal as an investment loan?

Let's say I have 300k loan for my PPOR (P&I), and by the end of the year, I would've paid off 30k of the principal (balance = -270k)
After that occurs, I can then ask my bank to lend me 30k as an investment loan, which will then be used for investing.

Keep doing this every year to top up the existing investment loan / increase the limit and/or create a new investment loan (to be used for different investment purpose for example).

Assuming I pay off 30k in the PPOR loan principal every year and do the debt recycling every year as above, at the end of year 10, I would have paid off the PPOR loan completely, but now I would have total 300k in investment loan(s).
All good - non-deductible interests that would otherwise be incurred by the PPOR loan are now converted to deductible interests incurred by the investment loan(s).

My questions:
1. Is my understanding of debt recycling above correct?

2. Will there be any pitfalls to watch out for, e.g. bank will not let you do this or certain things, etc.?

3. What if my current PPOR is in IO loan because the plan of converting this PPOR to an investment loan in the future? How can a debt recycling work in that case?

I was thinking two options:
a) do as the above (may need to switch the loan to P&I first?). Then, say in year 10 when the PPOR loan has been completely paid off, I will ask the bank to "redraw" 300k from the PPOR loan and use the money to pay off the investment loan(s).
Then, rent out the place and claim interests incurred by the 300k in the PPOR (now would be investment property) loan

Would the bank allow this?
From tax perspective, from what I read, this is considered as mixed loan and should not be done because affecting deductibility, correct?
which leads me to option b)..

b) Keep the PPOR loan as IO loan. Pump the money that would have been used to pay off the principal to the offset account linked to the loan.
Ask the bank periodically (say yearly) to create an investment loan with the limit of the same amount of money that I add to the offset account during that period as an investment loan.

For example, in a year I add extra 30k to the offset account, then ask the bank to create an investment loan with a limit of 30k (no money given to me - just open the investment loan).
Once the investment loan is setup, I then transfer 30k from offset to the new investment loan and use it to invest.

Is something like this possible and a prudent thing to do?

c) Any other options?

TiA

 

Your understanding is correct in parts worng in parts too.

If you have a PI loan the limit will be reducing over time.

You can use IO and debt recycle.

Debt recycling involves paying down non deductible debt and borrowing to invest.

Also if you pay off a loan on a property and later rent it out you wont have interest to claim against the property. So you have to make a choice to pay it down or not - you cant both not pay it down and debt recycle.

 

If i am on IO but want to debt recycle, i will need to pay down the principal? Would the bank allow that since I am on IO loan?

 

Yes
and Yes.

 

Hi Terry; I'm planning on debt recycling.

I'm on the top tax bracket, while my wife is on ~60k/yr.

If we purchase shares in her name for debt recycling, she will pay less tax on dividends than I would if they were in my name.

If we purchase shares in my name, I will reduce my high tax burden ?more by the interest on the investments.

Which is the better option ?

 

You should seek financial advice and specific tax advice on that. I cannot answer as the question is too vague.
Are you borrowing to invest?
will there be capital gains
will there be dividends?
Will the interest exceed the dividends etc etc

Perhaps you should look at discretionary trusts as well.

 

Yes re borrowing.

I am planning to set up a structure similar to your 'ideal loan structure' post, and then invest in something like ETFs when each PPR sub-loan (e.g. $50k) is paid off.

There would hopefully be both income and capital gains over 10 years

 

That is potentially a good idea, just get some advice before determining ownership structure.