Tax Tip 336: Debt Recycling in Advance

Where a person is currently renting where they live and are planning on moving into the property at some future date then it is possible to debt recycle in advance. That is they can pay down the loan, reborrow to invest now, before they move in.

This will not provide a tax benefit now, but it will potentially result in a good tax benefit at the point in which they do move in.



Example

Bart has purchased a property which is a place he plans to move into in 5 years. In the meantime he is living with parents and investing in shares.

The property has a loan of $500,000 and Bart plans to invest $50,000 into the share market every year.

Assuming Bart does not debt recycle at the end of the 5 years he will still owe $500,000 on the property (less the principal component if it is a PI loan) and have $250,000 worth of shares. When he moves in he will have no interest to claim plus the interest on the full $500,000 is non-deductible.

However, if Bart does debt recycle, at the end of 5 years when he moves in he will have one loan of $250,000 on which the interest is not deductible (less the principal component if it is a PI loan) and a second loan of $250,000 on which the interest will be deductible (less the principal component if it is a PI loan).

He will own the same amount of assets, have the same amount of debt, but he will have greater tax deductions and more money in his pocket.

If the interest on the loan is 2.5% the amount of interest on the $250,000 loan would be about $6,250 per year. This would mean each year he would have this much in extra tax deductions. At the top marginal tax rate this would result in approx. $3,000 per year extra cash in his pocket for the life of the loan (reducing slightly each year if the loan is PI).


The best thing is that this would cost him nothing to achieve, other than tax advice – which could be free if the broker is licensed to advise on tax.

 

Hi Terry, I'm in this scenario, a few months from moving in ...but don't understand what I missed? I have IP loan of 500k and about 480K cash/shares ready when I move in at which point will split loan/redraw/invest and debt recycle

During this time the whole 500K was already tax deductible. How would splitting the loan earlier have povided more tax advantage ?

 

If you moved in you would still have $500k in non-deductible debt. But if you debt recycled before you moved in, you would have deductible debt before and after.

 

Thanks @Terry_w would be nice to get this set up earlier.

but my thought was to refinance to a better PPOR rate and am guessing may need to reduce the loan balance as servicing would drop without rent. Would this earlier debt cycling loan set up cause issues when trying to do that ? I'd like to keep as much of the 480-500K as deductible debt as possible.

Is it possible to refinance for PPOR rates before moving in (eg. tenant still there or if reno-ing)?

 

Refinancing generally doesn't change deductibility of interest.

It is possible to get OO rates before moving in too.

 

The example used for debt recycling has one catch. Bart invested in shares. Selling those down to recycle may come with a CGT issue. The cost of tax being triggered should be carefully considered as part of the plan. There also may be costs to reinvest eg brokerage on the sale and brokerage on the repurchase and consideration of the exit and reentry timing may be a factor.

I am often asked if there is a way to recycle debt in this instance and not trigger CGT and that timing problem. In most cases there isnt BUT....If Bart had temporary access to other borrowed funds (ega parent, spouse etc) then it can also be considered since the final loan split draw down would merely discharge that loan and so a unbroken refinance chain occurs. There are additional legal costs which arent too signiifcant but Bart could refinance part of the home loan to someone else and achieve a recycling without selling down the shares, SOMETIMES. If he plans additional shares its more likley than if he plans to retain just those he already owns. In some cases its also time to consider restructuring the share ownership so they are newly acquired using newly borrowed funds. Eg a trust could acquire the shares and Bart could relend his borrowed funds to the trustee etc. The trustee of the trust should therefore not be Bart as a human trustee since Bart cant lend to himself.

 

my example involved no selling of shares. Bart was borrowing to buy them from the beginning so the interest is deductible against the share income from the beginning.

 

I get loads of people who own shares and later realise they could have been debt recycling.

 

sadly that's me. Going to face a hefty CGT tax, might need to draw out the timing of selling shares
hope other people in same boat sees this tax tip first

 

The March 2020 period was a time for that. I had a few rejig their strategy at that time. Suggestion:
Calc the proposed CGT and consider timing of discount v non-discount events.
Consider a strategy that occurs at different times to break down the cost or just dont "fix" certain holdings now.

 

thanks Paul. Yes covid was unexpected and the opportunity in shares too good to be missed but didn't think things through. I've got a countdown on shares of when their 12 months tick over, will phase some selling in FY21 and others in FY22, might keep holding some beyond that and take the hit from missed tax deduction

 

Remember losses can offset non-discounted gains too.

 

Along the same theme, here's a slightly different scenario I'd love thoughts on:

Bart has two IPs and is a renter himself.
IP1 is owned outright, no debt.
IP2 has a $270k I/O mortgage with $150k in offset against it.

Bart's rental is ending and he has to move into IP2 (he cannot move into IP1). How does Bart structure his lending so that the deductible interest is against IP1?

(Bart thinks he should access the equity in IP1 to top up IP2's offset to the full $270k, but he's unsure about the security versus purpose aspect of such a loan.)

 

Security for a loan has nothing to do with deductibility.

 

He cant

 

@Terry_w @Paul@PAS Thank you for sharing your wisdom. In Terry's example in original post, Bart debt recycle by paying down $250k loan and redrawing it for share investment, and therefore this redrawn $250k loan became tax deductible. My understanding is that Bart could do this strategy (paying down loan & redrawing it) long before, slightly before or even after moving into the property (property changed status from IP to PPOR) and he would successfully debt recycle the $250k to be tax deductible. Is my understanding correct? The sooner he does it, the sooner he makes the loan tax deductible, of course the better. For example, Bart wanted to debt recycle the $250k as deposit for next IP, and due to borrowing power or other reasons, he could only do it 2 years after moving in to his first property, Bart would still can debt recycle successfully even if the strategy is done 2 years after moving in, right?

 

Only interest could ever be potentially deductible. The idea is to debt recycle in advance if investing so that when you do eventually move in you will have low non-deductible debt.
In the meantime there will be no tax difference, assuming same ownership entities.

 

I have a client issue where they debt recycled long long before any investment. Funds went to savings for up to 2 years The timing of new income producing investments and borrowing do not correlate. The investments include many many different dates and many dont produce income. I cant work it out. Its so remote i believe nothing can be determined. If you could it would cost a mint. Perhaps an actuary?

This is also the ato view. Many taxpayers think they have certain positions. Arguably if i cant work it out the ato wont either

The Bart example is good. Bart isnt the brightest. I often need to advise clients they didnt comprehend and are wrong. Moving money does not mean you prove deductibility