Tax Tip 88: Use cash in offset to invest or pay down loan and reborrow?

Discussion in 'Accounting & Tax' started by Terry_w, 29th Nov, 2015.

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  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Plus Member

    9th Jun, 2006
    Australia wide
    I think I have touched on this idea before, such as in this thread Pay less LMI and borrow less or borrow more and maximise deduction?, but will elaborate on my ideas below.

    Firstly note that it would always be best, from a tax point of view, to borrow to invest. But what if you don’t have equity, but you have cash in an offset account on an investment property? Taking it out or paying down the loan and reborrow would seem to have the same tax consequences - until we dig deeper.

    Example Scenario: where Tom is single
    Tom lives with his parents. He has a $500,000 investment property with a $500,000 loan outstanding which was used to purchase an investment property. He also has $200,000 cash in the offset account attached to this loan.

    Tom buys a second investment property for $200,000. He buys in his name. He has a choice as to how to fund it.

    He can do any of the following scenarios:
    1. use $200,000 cash from his offset; or
    2. pay $200,000 off the loan for IP 1 and then reborrow; or
    3. use say $25,000 cash from the offset and borrow the rest; or
    4. pay down the loan on IP1 by $25,000 and reborrow and use for the deposit and borrow the rest secured by the new property.

    Firstly I would rule out 1 and 2 if it is still possible to borrow. Tom should keep his cash for the future PPOR. Tom may have equity built up which he could tap into and this would be the ideal.

    Secondly if Tom was going to live in either property then it would be best to have as little borrowed for this property as possible.

    Which method is ‘best’ will depend on a number of things such as
    1. Will Tom be the owner of the new property?
    2. Will Tom live in either property, now or in the future?
    3. Does Tom have parents or friends to borrow from?
    4. Does Tom have a spouse?

    If Tom was not going to be the sole owner of the second IP it would depend on who the owner would be and their situation.

    Scenario 1
    If Tom takes $200,000 from the offset account the interest on IP1 will increase by about $200,000 x 5% = $10,000 per year. Tom can claim an extra $10,000 against the income of IP1. This won’t be a good option if Tom is planning to buy a different main residence in the future as he will have $10,000 per year in less tax deductions.

    Scenario 2
    If Tom pays down IP 1 and reborrows $200,000 the interest incurred will be the same. But the consequences different because the $10,000 interest will be deductible against the IP2. If Tom is the owner of IP1 and IP2 there will be no immediate tax difference.

    But if Tom were planning to live in IP1 later then this would be advantageous as he would have paid off his non-deductible debt.

    Scenario 3
    Tom could just take the deposit money from the offset and borrow the rest for the purchase of IP2. This is good, but the deposit money will be tied up and cannot be used for any future main residence purchase. It would be better than using the cash to purchase the whole property as it increases borrowings.

    Scenario 4
    Tom could pay down the loan on IP1 by the deposit amount and then reborrow this. The interest on the deposit would then be deductible against IP2.

    The trouble with this is, similar to scenario 3 above, the deposit money is tied up in an investment property. But this may be better than the other choices if there is any chance the IP1 could become owner occupied.


    Where there are spouses involved it is whole different issue.

    Example scenario where Tom has a spouse

    Imagine the same situation as above but Tom suddenly found a spouse, Nancy. Let’s assume that Nancy will now be the one that buys the $200,000 IP.

    Scenario 1A
    Tom could lend Nancy $200,000. If he does this the interest on Tom’s $500,000 loan jumps. This allows Tom to claim more interest. This could be a good option if Nancy has a lower income than Tom as Tom would save more tax than Nancy would pay.

    Tom could gift or loan at 0%. There will be no direct and immediate tax consequences because this is just cash for Tom. i.e. he did not borrow the money. However there are later tax consequences to Nancy if Tom wants his money back. Nancy may need to borrow to give Tom the money back.

    Where Tom had gifted the money to Nancy the interest on Nancy’s loan will NOT be deductible.

    Where Tom had lent Nancy the money at commercial rates and terms and this was evidenced by a written agreement then Nancy should be able to claim the interest on the new loan as this is just the refinancing of one loan with another.

    However where Tom had lent Nancy the money at Nil interest then the ATO may have issues with this where Nancy refinances a uncommercial loan with a normal bank loan and they MAY deny the interest deduction. This is why it is important to seek tax advice before implementing this.

    Scenario 2A
    This may only be a good idea where the IP1 may become the main residence in the future. Even if that was the intention it would still be a good idea to lend the money to Nancy instead as Tom would not be paying down debt.

    Scenario 3A
    Tom could lend Nancy the $25,000. This is probably the best choice in this instance. This will maximise borrowings with banks and allow for maximum flexibility no matter which property ends up as the main residence. This is because the money in the offset account could be moved around to the property in which they will live.

    Scenario 4A
    Since there is a second party buying the new property there should be no reason to pay down Tom’s loan.

    Summary Tom and Nancy
    Ideally, in this situation Tom would lend Nancy the minimum deposit to buy the new property. Tom’s interest on his loan would increase as funds are removed from his offset account, but he will be able to claim the interest on the loan, including the extra interest incurred because of the withdrawal. Tom and Nancy should seek tax advice on the terms of the loan such as the interest rate. Once Nancy’s property increases in value she should then increase her main loan and repay Tom his money again.

    Where Tom and Nancy are still renting or living with parents it would be a good idea to put their cash money into the offset account against the loan in the lower income earner’s name. But both taxation and legal advice should be sought about this as there are many other issues including the inability to lend each other money in the future where all their funds are pooled.
    Peter P likes this.
  2. norwoodman

    norwoodman Well-Known Member

    20th Jun, 2015
    Adelaide SA
    Hey Terry_w, a couple of other what ifs to throw in to your scenarios.

    How might the outcomes of the scenarios change if Tom only had $50k in offset rather than $200k?

    Also, expanding on scenario 3 - what different options would Tom have for going about borrowing the rest of his deposit?
  3. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Plus Member

    9th Jun, 2006
    Australia wide
    Similar if the cash is less - but he won't be able to pay cash for the property. Other options would be the same still.

    Tom could borrow from parents, use parental property as security for the new IP, could even use his cash as security too.
    Tax Tip 61: How to borrow 105% on your first purchase
  4. Threebythree

    Threebythree Active Member

    1st Jul, 2015
    ^ though this is pre-APRA, am curious in this environment.
    1. If lending between 2 related people, does the interest rates need to be @market rate or greater? If the latter, where is the value to the borrower at a higher rate?
    i am thinking 'market rate' could be at the lowest rate in the current market including non-banks lenders?
    2. If you loan from the bank first, lending approves, then borrow for the deposit, would borrower thus effectively get a 100% loan - and still be above board?
  5. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Plus Member

    9th Jun, 2006
    Australia wide
    1. no doesn't need to, but whether you should have the rate at market rates needs considering.

    2. yes, you could borrow more than 100% - and probably should.

    I can't think of anything that would change above post 'apra'.