Debt recycling offers lower taxes, greater investment opportunities

In the eyes of the Australian Taxation Office (ATO), not all debt is equal.

In Australia, the ATO permit taxpayers to claim a tax deduction for interest incurred on investment-related loans. Interest, however, on private (as opposed to investment-related) loans is not tax deductible.

So, what exactly are considered tax deductible investment loans?

By and large these are loans taken out for the purpose of acquiring income producing assets or investments. It could be, for example, a mortgage to acquire an investment property, or a margin loan to acquire listed shares.

So, what loans then are considered private in nature and why is there no tax deduction allowed for such loans?

Private loans typically exist when non-income producing assets or investments are bought. Common examples are acquiring your family home, as well as a car or boat, even outstanding credit card debt.

To be considered tax deductible, there generally must exist a nexus between an expense to assessable income. In the case of loan interest, the necessary nexus is the taxable investment income being earnt, for example rental income, dividend income, etc.

There is no taxable income to ascertain from your family home and other such personal chattels. As there is no tax nexus, any interest incurred is thereby non-deductible.

But does the tax deductibility status of a loan really make that much difference? After all, if you pay $10,000 of interest, then whether it is personal or investment related you have still paid $10,000 … correct? Well, not exactly.

It is true that in both circumstances you have paid the bank or finance company $10,000 in interest, but it is the after-tax cost of that interest that is most relevant.

To illustrate:

An individual has $150,000 of taxable income. This places them in the 39 per cent (being 37 per cent + 2 per cent Medicare levy) tax bracket.

A $10,000 tax deduction at 39 per cent equates to a $3,900 tax refund. The after-tax interest cost is therefore $6,100 (being $10,000 – $3,900).

If on the other hand the loan was of a private non-tax-deductible nature, then that same individual must actually earn $16,393 (being $10,000 / (1 – 39 per cent)).

At 39 per cent marginal tax rate, earning $16,393 will result in $6,393 in income tax being paid (being $16,393 x 39 per cent), thus leaving $10,000 remaining with which to pay the bank or the financing company.

In other words, the “same” $10,000 of interest will either cost you $16,393 if the loan were personal in nature otherwise $6,100 if the loan were investment in nature.

Table 1: Comparison of $10,000 interest paid at various marginal income tax rates – $10,000 Interest Paid.

Marginal Tax Rate (Incl Medicare)	0%	21%	34.5%	39%	47%
Private Loan	$10,000	$12,658	$15,267	$16,393	$18,868
Investment Loan	$10,000	$7,900	$6,550	$6,100	$5,300

Table 2: Effective interest rate of a 7% p.a. loan at various marginal income tax rates – 7% Interest Rate.

Marginal Tax Rate (Incl Medicare)	0%	21%	34.5%	39%	47%
Private Loan	7.00%	8.86%	10.69%	11.47%	13.21%
Investment Loan	7.00%	5.53%	4.58%	4.27%	3.71%

For someone earning above the top marginal tax rate of 47 per cent, private debt is almost a staggering four times as expensive as investment debt!

So are there any ways to be able to convert private non-tax-deductible interest into tax-deductible investment interest. The short answer is yes and one such strategy is a concept known as debt recycling.

Debt recycling explained

At its heart, the principal of debt recycling is to physically pay down a private loan and physically redraw it to fund the acquisition of an income producing investment. This can be done in one go or, alternatively, piecemeal via multiple loan splits.

Case study 1:

Several years ago, a person bought their family home. Their remaining mortgage currently stands at $1 million. They have $250,000 in savings currently in their bank account. They are wanting to invest the full $250,000 into dividend-paying listed shares.

The process starts by splitting their home loan into $750,000 and $250,000, paying down the $250,000 loan to a nominal $1 using cash savings, and subsequently redrawing the funds to acquire the listed shares.

There is still $1m in total loans, as the strategy of debt recycling is not necessarily about borrowing more, rather converting the characteristics of the original loan.

So, from the original position of $1 million in private loans there is now $750,000 in private loans and $250,000 in tax deductible investment loans – tax deductible by virtue of having created the necessary nexus to assessable dividend income

Case study 2:

Similar to scenario 1, a person has a $1 million loan remaining on their main residence home. They have accumulated $1 million in savings, which they were planning to put towards buying a $1.5 million investment property.

In this situation further borrowing of $500,000 is required to be able to acquire the investment property (putting aside stamp duty and other transaction costs).

Paying down the existing $1 million private main residence home loan in full (to a nominal $1) then redrawing back out the full $1 million to contribute to the investment property purchase results in 100 per cent of private debt having been eliminated. While the original loan still exists, it has been completely recharacterised into tax deductible investment debt.

A superior tax outcome has therefore been achieved, as the $1.5 million investment property now has $1.5 million tax deductible loans attached to it, as opposed to the initially proposed $500,000 loan.

Although the underlying security or collateral for the original $1 million loan continues to be the main residence, the debt recycling strategy has changed the use of the funds. The interest on monies borrowed is attached to the asset acquired. The process of paying down the original loan effectively extinguishes the original use of the funds to buy the main residence and replaces it with the new use, being to buy the investment property.

There are several variations to the above two case studies that can assist with a debt recycling strategy, including selling existing (typically liquid) investments to generate sufficient cash holdings to pay down private loans.

Tricks and traps of finance repositioning

As with any tax strategy, be sure to obtain professional advice as it is imperative that the arrangement be structured appropriately to not only enhance any available tax savings but also to ensure and maintain ATO compliance.

A common trap, for example, occurs if the investments funded by way of a debt recycling strategy are subsequently sold. To ensure 100 per cent tax deductibility of the loan is maintained, the amount borrowed to acquire the underlying investment needs to either be repaid or the funds reinvested. Spending the sale proceeds on personal use items while leaving the full loan untouched can reduce the investment use component. Accordingly, one may end up with a lower proportion of tax-deductible interest.

A debt recycling strategy can be highly advantageous in improving an overall tax position through converting private loan interest into tax deductible investment loan interest. There are certainly a few tricks and traps to be mindful of, and the provision of appropriate professional advice will go a long way to ensuring you can maximise potential tax benefits.