Most of us know that when we take out a mortgage loan to buy an investment property that we are allowed to claim a tax deduction for the interest we pay on the loan. And if the amount of interest we pay on the loan is less than the rental income we earn that we are able to claim the difference as a tax deduction to help us pay less income tax overall. This is commonly referred to as negative gearing. Although having a short fall upfront does not sound that appealing, the usual expectations is that over time, the value of the property will and the rental income will increase. 

The fact that we get a tax deduction against our other income now (such as wages) and can reduce our tax by up 45% (depending on individual tax rates) is appealing to those borrowers who have excess income – especially considering that capital gains tax is only half the rate of income tax.

The rules around whether the interest on a loan is tax deductible

Without going into all the detail a borrower is permitted to claim a tax deduction for the interest they pay on an investment property loan because it’s an expense (allowable deduction) incurred while earning what is known as Assessable Income (the rent).

It is important to know that Assessable Income does not include capital gains. This is dealt with separately under the Capital Gains Tax (CGT) rules, so you’ll need to keep this in mind and seek advice where necessary when deciding to buy an investment property.

The Purpose Test

There is a common misconception that the property which is being used as the security for the investment loan is what is used to determine whether the interest on the loan is tax deductible, but in most cases this is almost totally irrelevant. The rules determining whether the interest on a loan is tax deductible is primarily based on the purpose of the borrowing.

For example, even if you use your principal place of residence as security to borrow to buy an investment property the interest on that loan should still be deductible.  You will need to keep accurate records of how the loan funds were used so you can show these to the tax office in the case of an audit. Keeping these records is known as traceability – being able to clearly demonstrate that you used the money to purchase an asset that is expected to earn income.

Also be careful when re-financing loans and do not mix up your loan purposes so you make sure you maintain your maximum tax deductibility. Too often I see borrowers trying to simplify their home loan only to lose valuable tax deductions forever.

The Offset Account

Armed with a basic understating of why we are allowed to get a tax deduction on loan interest when we buy an investment property, we should now consider how we can use 100% Offset Account to make sure we don’t accidently lose the benefit without paying any more interest than we should. The main point is that an Offset Account is separate from the loan account but when funds are deposited into the Offset account, we still save the same amount of interest we would have had we repaid the loan directly – but importantly if we ever need that money back, the original loan purpose did not change. 

This is best illustrated by an example below.

Bob buys an investment property for $500,000 and borrows the money by offering a mortgage over his owner-occupied home worth $750,000. The interest on this loan is still tax deductible even though the investment property is not mortgaged, because the purpose of the loan was to buy an asset that will produce assessable income.

Sometime later, Bob gets a windfall of $200,000 and would like to use this to save interest on his investment property; if he has an Offset Account, he has 2 options:

1. Pay the $200,000 off the mortgage or
2. Deposit $200,000 into the Offset account

Regardless of which option he chooses he will save the same amount of interest but electing to put it into the Offset Account has one major advantage – he has not repaid any part of his loan where he is currently entitled to claim the interest as a tax deduction. If Bob never needs to use those funds again there is no harm done, the damage only occurs if he ever needs to access those funds again for personal use. You see that once that $500,000 has been repaid – it has been repaid forever and any future re-draw against from the loan then has its own unique loan purpose. 

Once a tax-deductible loan has been repaid – it has been repaid forever.

If 8 months later Bob wants to renovate his home and re-draws $200,000 to pay for it he has a problem, because the loan purpose has changed. Bob still has a $500,000 loan – but now only the interest on $300,000 of the loan can be claimed as a tax deduction because that “redraw” of $200,000 had a new and different purpose of being used for personal purposes and is no longer tax deductible. Bob has unintentionally diluted his $500,000 tax deductible debt and in the process created a bit of an accounting nightmare, where it becomes impossible to identify which portion of the loan is being repaid in the future because as he makes future loan repayments there is no clear way to determine whether he is reducing the original tax deductible loan of $300,000 or the $200,000 non-taxable loan. Bob will claim that he wants to repay the loan on which he does not get a tax deduction first, but the tax office may determine otherwise.

Bob could have avoided all these problems if he had an Offset Account . An Offset account is a totally separate account which is linked to the loan account and reduces the gross amount of the loan account to give a net balance each month, which the bank then uses to calculate interest. The Offset account acts like a savings account where Bob could have “parked” the $200,000 for as long as he wanted to without altering the original loan purpose while saving an identical amount in interest.

While we never can be sure of what will happen in the future we can keep open as many “free” options available as possible if we consider how our circumstances might change over time.  

The use of Offset Accounts is a feature that I’d been reluctant to forego when selecting the right loan, but even if you have the wrong loan in place, it’s always worth speaking to a Mortgageport expert to see if it’s not too late to set things right. Getting these decisions right become much more important as interest rates and tax rates increase.