Interest deductions: risks and opportunities

This tax season, we’ve seen a surge in questions about whether interest on a loan can be claimed as a tax deduction. It’s a great question as the way interest expenses are treated can significantly affect your overall tax position. However, the rules aren’t always straightforward. Here’s what you need to know.

The purpose of the loan

The most important thing when looking at the tax treatment of interest expenses is to identify what the borrowed money has been used for. That is, why did you borrow the money?

For interest expenses to be deductible you generally need to show that the borrowed funds have been used for business or other income producing purposes. The security used for the loan isn’t relevant in determining the tax treatment.

Let’s take a very simple scenario where Harry borrows money to buy a new private residence. The loan is secured against an existing rental property. As the borrowed money is used to acquire a private asset the interest won’t be deductible, even though the loan is secured against an income producing asset.

Redraw v offset accounts

While the economic impact of these arrangements might seem somewhat similar, they are treated very differently under the tax system. This is an area to be especially careful with.

If you have an existing loan account arrangement, you’ve paid off some of the loan balance and you then use a redraw facility to access those funds again, this is treated as a new borrowing. We then follow the golden rule to determine the tax treatment. That is, what have the redrawn funds been used for?

An offset account is different because money sitting in an offset account is basically treated much like your personal savings. If you withdraw money from an offset account you aren’t borrowing money, even if this leads to a higher interest charge on a linked loan account. As a result, you need to look back at what the original loan was used for.

Let’s compare two scenarios that might seem similar from an economic perspective:

Example 1: Lara’s redraw facility

Lara borrowed some money five years ago to acquire her main residence. She has made some additional repayments against the loan balance. Lara redraws some of the funds and uses them to acquire some listed shares. Lara now has a mixed purpose loan. Part of the loan balance relates to the main residence and the interest accruing on this portion of the loan isn’t deductible. However, interest accruing on the redrawn amount should typically be deductible where the funds have been used to acquire income producing investments.

Example 2: Peter’s offset account

Peter also borrowed money to acquire a main residence. Rather than making additional repayments against the loan balance, Peter has deposited the funds into an offset account, which reduces the interest accruing on the home loan. Peter subsequently withdraws some of the money from the offset account to acquire listed shares. This increases the amount of interest accruing on the home loan. However, Peter can’t claim any of the interest as a deduction because the loan was used solely to acquire a private residence. Peter simply used his own savings to acquire the shares.

Parking borrowed money in an offset account

We have seen an increase in clients establishing a loan facility with the intention of using the funds for business or investment purposes in the near future. Sometimes clients will withdraw funds from the facility and then leave them sitting in an existing offset account while waiting to acquire an income producing asset. This can cause problems when it comes to claiming interest deductions.

First, even if the offset account is linked to a loan account that has been used for income producing purposes, this won’t normally be sufficient to enable interest expenses incurred on the new loan from being deductible while the funds are sitting in the offset account.

For example, let’s say Duncan has an existing rental property loan which has an offset account attached to it. Duncan takes out a new loan, expecting to use the funds to acquire some shares. While waiting to purchase the shares, he deposits the funds into the offset account, which reduces the interest accruing on the rental property loan. It is unlikely that Duncan will be able to claim a deduction for interest accruing on the new loan because the borrowed funds are not being used to produce income, they are simply being applied to reduce some interest expenses on a different loan.

To make things worse, there is also a risk that parking the funds in an offset account for a period of time might taint the interest on the new loan account into the future, even if money is subsequently withdrawn from the offset account and used to acquire an income producing asset.

For example, even if Duncan subsequently withdraws the funds from the offset account to acquire some listed shares, there is a risk that the ATO won’t allow interest accruing on the second loan from being deductible. The risk would be higher if there were already funds in the offset account when the borrowed funds were deposited into that account or if Duncan had deposited any other funds into the account before the withdrawal was made. This is because we now can’t really trace through and determine the ultimate source of the funds that have been used to acquire the shares.

To do

It’s worth reaching out to us before entering into any new loan arrangements. In this area, mistakes are often difficult to fix after the fact, which can lead to poor tax outcomes. That’s why getting advice from a tax professional before committing to a loan is essential. We can work alongside you and your financial adviser to ensure your loan is structured in a way that makes financial sense and protects your tax position.