Tax tip 342: Tax Issues with Loan Recycling

Tax tip 342: Tax Issues with Loan Recycling


I mentioned that it is possible to recycle loans – that is keep the loan open when the asset it was used to acquire is sold. The loan can be be reused

See

Loan Tip: What is Loan Recycling?

Loan Tip: What is Loan Recycling?


But there are tax issues to consider. If a person keeps a loan open and the asset it related to is sold, the interest on that loan will no longer be deductible (with a limited exception).

This you have to think about how the extra money is used. Doing things in the right order can allow for more interest to be claimed.


Example

Homer has a property which he is selling, Property A. Loan 1 was used to buy Property A many years ago. It was $400,0000 and has been interest only for the full time that Homer bought the property for $500,000.

Now the property has doubled in value and Homer is selling it. The trouble is he can’t qualify for a new loan.

Luckily (?) he purchased a similar property down the road, Property B, which is now worth $1mil and has a loan of $400,000 secured against it, Loan 2. Homer is keeping this one.

Planning well in advance, Homer gets the lender, the mortgagee, to change the security of Loan 1 to Property B.

Property A is now unencumbered. Homer sells it and doesn’t pay out Loan 1.

Homer has $1mil in his hand which he uses to buy another property. None of the interest on this property is deductible.


What Homer should have done is debt recycle as well as loan Recycle.


Example 2

Just before Homer is about to sign the contract for the new property he gets some tax and legal advice

Homer then takes $400,000 from the sale and pays Loan 1 down to $1 and Redraws it to purchase the new property.

Going forward, if the property is rented out, Homer can then claim the interest on Loan 1 against the new property.

This gives him $12,000 per year extra tax deductions saving him about $6,000 in tax – per year (which may drop over time, especially if Homer stops paying the top marginal tax rate).


This strategy also

- Allow Homer to sell yet still have the same number of properties

- Use part of the sale proceeds of Property A to supplement his retirement income

- Retire earlier

- Still keep the new property unencumbered yet borrowed for, as well as

- Save tax.

 

Hi Terrry,

From example 2: Homer has to sell Property A first, pay down its loan to $1, then redraw to buy Property B.

Say Homer found Property B but his Property A is still sitting on the market waiting for a buyer. Homer has cash savings of $500K which he can use to buy Property B outright but still wants to keep Loan1 post the sale of Property A as he longer qualifies for another loan. So if Homer buys Property B using cash before selling Property A, then once A is sold, Loan1 can be recycled, secured against B but interest on this loan is no longer tax deductable.

Is there anything Homer can do in this situation in order for loanA to be tax deductable against Property B?

Just curious. Thanks for sharing

 

Yes. Think about it...

 

yes if Homer sells A first, pays down the loan to $1 then redraw to buy B .... this should work

but the question is for a hypothetical scenario of the opposite order ....where Homer buys B unencumbered, then sells A & swap the security... which would make the loan interest on the swapped security no longer tax deductable...hence the question

 

think more

 

I guess the other option would be if Homer obtains a loan2 to buy B then once A is sold he refinances out to swap loan 1 with loan2 and using B as security on loan1 ? but this will only work if he can borrow loan2 which in this case he can't due to retiring ... more clues needed please

 

What if Homer used the cash to pay down loan A, Redraw and then buy B. Then swap the security of the loan from A to B.

 

yes! that's a great idea .. you are a genious

 

Sometimes the solution is a simple yet not evident

 

very true ... thanks for sharing

 

If loan 1 is paid down to $1 after sale of property A.. is the lender going to have a tizzy if property A is then sold, and substitution happens much later?

As they then have no security, other than the money in the loan account, which could then be redrawn?

So is this a timeliness issue? i.e. you must have a pending purchase ready to substitute asset security immediately?

Maybe this is more related to Loan Tip: What is Loan Recycling?

 

if the security is sold the loan has to be paid out or substituted before the settlement of the sale. not sure what you mean

 

What if all the details above were the same wrt to Loan 1 and 2, but instead of selling Property A and buying a new property, Homer released Property A and refied up to 80% with another lender for a pure cashout.

He would have $800K as cashout with a new lender and $400K still open with the first lender. What could he do to keep all funds tax deductible (if he wasn't buying another property)?

 

Are you asking how he could borrow money, but not use it, and claim the interest?

Not much he could do other than lobby for a change in law

 

Kind of lol

 

Hi Terry

what is the required mechanism by which the loan would be “paid down” to $1? Does this mean paid off (balance reduction) and then Reborrowed from The bank? Or is it good enough for the funds from the sold property to just sit in the loan account for a while?

 

depositing into the loan is paying it down. Redrawing is borrowing again.

 

Thanks Terry

So what if Homer used the proceeds from the sale of a property to pay down his PPOR loan, then redrew the loan to purchase an investment property? I’m assuming that loan would become tax deductible and reclassified as an investment loan?

 

Interest could be deductible but it doesn’t have to be designated an investment loan